Fairbairn logo - go to homepage
| Home | | On-Line Demo | Which Services? | Links | FAQ's |
Search
Go

Bonds - beyond the headlines - an asset class for the long term

Introduction

The past few months have seen many a headline in the press warning investors that "bonds" are in bubble territory and with yields at historical lows, they offer no value at current levels. Whilst we would agree that government bond issues of some developed markets look very expensive and offer little cushion against either interest rate rises or inflation, we would caution investors against writing off the entire asset class. Indeed, Fairbairn Private Bank would recommend that a bond allocation should continue to be a core holding within a private client's investment portfolio. That said, given that the easy money has been made, the challenge going forward is to select and access the right sub sector(s) and actively manage the changing risks.

Where is the value?

In terms of the sectors we prefer at this time, we continue to believe that corporate debt (issued by companies as opposed to countries or banks) is attractive, particularly those bonds occupying the upper end of the high yield space (rated BB/B) which Goldman Sachs forecast to deliver returns of circa 8 - 9% in 2011 (Long US High Yield Corporate Spreads). The additional spread (ie, the extra yield a holder is paid above the so-called "risk free" government bond of the same maturity) is still above the historical average and with default rates continuing their decline and credit ratings improving, the risk adjusted return they offer is very attractive.

Another pro-cyclical fixed income sector is emerging market debt. Our preference is for local currency issues, particularly corporate bonds. We acknowledge the growing risk of inflation in these markets, however, as interest rates rise it is anticipated that their currencies will strengthen benefiting the owners of local currency bonds.

Finally, changing demographics and ageing populations in developed countries are increasing the demand for yield assets and bonds continue to be an important component of retirement solutions. Support for bonds also comes from regulatory changes which require the banks and insurance companies to hold more government debt for liquidity purposes.

Where are the headwinds?

In terms of the specific headwinds facing investors in 2011 these include:

  • a continued rise in bond yields
  • further concerns regarding European peripheral countries and the solvency of their banking systems
  • rising interest rates and
  • the "concern of the moment" - inflation.

With respect to the latter, rising commodity prices, and to some extent weak currencies, are tending to push inflation through to developed economies, however, the current global excess capacity (a situation in which actual production is less than what is achievable or optimal) means we do not presently see inflation as a big issue near-term. That said, we are monitoring it closely and, in the coming months, will begin positioning portfolios for the return of significant inflationary pressures. We have already undertaken some asset allocation changes to protect against rising interest rates and it is anticipated this will remain a theme throughout the year and beyond.

The 2011 outlook

Bonds should provide capital stability and cash flow - despite their recent impressive returns - they are not ideal assets for making you rich. It is important, therefore, to temper expectations as to what they can deliver over the coming year - returns of 2009 and 2010 will not be repeated in the near-term. That said, whether held for their income characteristics, capital preservation, portfolio diversification or a combination of all three, we recommend that an allocation to bonds continues to play a role in investors' balance sheets.

Investors should expect:

  • The economic environment to remain uncertain, with continued volatility across all risk assets
  • Future performance to be more muted but credit (ie, bonds which trade at a higher yield than the core developed government debt) will still generate attractive returns relative to the risk
  • The search for yield to continue, helping higher spread names (ie, issuers with a higher relative yield) to outperform
  • Emerging market currencies to continue to strengthen.

Investors need to:

  • Focus on what Bill Gross (MD of PIMCO - the world's largest fixed income fund manager) refers to as "safe spread" which derives its returns from credit risk as opposed to interest rate risk (ie, emerging market corporates, sovereigns with higher initial real interest rates and wider credit spreads and floating rate as opposed to fixed interest obligations)
  • Pursue a diversified approach across the appropriate fixed income sub-sectors and currencies to hedge against the economic unknowns.

The Fairbairn Private Bank discretionary managed global bond portfolio, with its unconstrained nature and capital preservation mandate, continues to offer investors a suitable income orientated investment solution. In the 25 months since its launch, this low to medium risk strategy has returned 27.68% (net of fees) - significantly in excess of its cash plus target. As trusted stewards of our clients' discretionary portfolios, we remain confident of our ability to seek out value and take advantage of the investment opportunities the international bond markets offer, whilst actively managing the ever changing risks.

For further information, please contact your relationship manager directly or our client services team on +44 (0) 1624 645000.

Disclaimers

Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit and inflation risk. Investing in foreign denominated securities may expose the holder to currency fluctuations and economic and political risk, which may be enhanced in emerging markets. Currency rates may fluctuate significant over short time periods and may reduce the returns of a portfolio.