What next for bonds?
How times have changed. Only a few months ago most economists
and investors were focused on the spectre of deflation, as central
bankers around the world battled to keep their economies from
plunging off a cliff. The unprecedented and powerful combination of
reducing interest rates to near zero and the implementation of huge
government stimulus packages - so-called quantitative easing -
would seem to have averted the risk of a depression. However, many
are beginning to ask - at what cost? Will the return of rampant
inflation be the price we will have to pay for saving the world's
economy?
The current economic position has been described as being the
point of maximum confusion in the multi-year transition of the
global economy, markets and policymaking. This phrase would also
seem applicable in the context of the bond markets. While most
participants agree that inflationary pressures will be an issue in
the coming years, there is less of a consensus as to when they will
return and just how severe they will be.
Critics argue that the spare industrial capacity, rising
unemployment and the decrease in lending (with much of the new
money supply sitting on bank balance sheets rather than being lent
out as loans), mean that inflation is unlikely to be a near-term
threat. Why then does inflation seem to be gathering so much
attention? One explanation is the fact that we are, in many ways,
in unchartered territory. Never before have governments extended
such credit and it is unclear how and when this will be unwound.
Rather than see a repeat of the 1930s, in the form of a double dip,
"W" type recession, some fear that central bankers may instead
choose to leave too much liquidity in the system for too long, thus
stoking inflationary pressures.
So where does this leave a wary bond investor? Should they
sell-up now or are there strategies that might help them manage
through a challenging period? There is no question that planning
for inflation is crucial - rising inflation leads to rising
interest rates, which causes bond prices to decline. Only when a
bond matures and can be reinvested at those high prices will
investors benefit. Inflation hedging strategies will therefore need
to be part of any well managed bond portfolio in order to deliver a
positive "real return" and thus protect against a fall in the
spending power of the investments.
In terms of what inflation hedges are best, an investor has to
consider amongst other things: their risk tolerance, the resources
available for managing such specialised assets and the period of
time the funds can be tied up for.
Perhaps the most well known real return strategy is to invest in
inflation-linked bonds - known as "linkers". These are securities
where the bond is indexed to inflation. They are predominantly
national government bonds, with privately issued bonds constituting
a small portion of the market and, as a consequence, their returns
tend to be relatively low. An investor should also keep in mind
that if sold before maturity he/she may find themselves with a
capital loss, assuming the market price has fallen during the
investment period.
Linkers are not the only solution, however, as a number of other
real return strategies exist. These include Floating Rate Notes
(FRNs) which are similar to adjustable rate mortgages except they
are securities not loans. The FRNs have a variable coupon (interest
payment), tracking a stated interest rate, for example, LIBOR, plus
an additional payment relating to the credit risk of the issuer.
Most FRNs pay out interest every three months.
Alternatively investors may choose to buy individual index
linked or floating rate note bonds, or funds which specialise in
such securities. Other collective solutions include what are
referred to as absolute return, total return or unconstrained bond
funds. In general such strategies have no requirement to closely
track an index. The resulting investment flexibility offers such
funds the option to go zero or even negative duration. A bond's
duration, a figure derived from several factors, measures the
bond's sensitivity to changes in interest rates. Therefore,
at the discretion of the collective fund manager, and using futures
and swaps, the inflation risk may be largely removed from the
portfolio.
Investing in local currency denominated bonds from issuers in
emerging economies offers two potential sources of return. The
first being the income from the interest payment, which are
generally higher than those of emerged nations due to the
additional credit risk. The second is the potential for currency
appreciation as a consequence of global rebalancing. Such
investment is not for the faint hearted and use of active fund
managers is recommended.
Fairbairn Private Bank aims to preserve capital while generating
income and are taking steps to gradually adjust the mix of
investments, in anticipation of the return of an inflationary
environment. Fairbairn Private Bank's sterling bond portfolio
offers investors access to the fixed income market. Available as
part of the bank's discretionary investment management service, for
clients with £250,000 or more to invest, the strategy aims to
deliver returns in excess of cash. The portfolio has the
flexibility to hold funds invested in sovereign (ie, government)
and/or investment grade corporate debt and when appropriate, the
mandate may also make satellite investments into emerging market
and high yield debt. Fairbairn Private Bank has negotiated
preferential terms with virtually all the major fund management
houses and in most cases access a fund with no upfront charge and
pay a reduced ongoing management fee. These savings are all passed
onto the client.