Liontrust Asset Management : Why own bonds in 2021?

Debt, debt, everywhere, nor any income to take. The current situation is not as bleak as this rewriting of Samuel Taylor Coleridge's famous lines suggests, but with the UK and other governments notching up record levels of borrowing, it is wise for investors to review their exposure to bond funds, what role they are playing in their portfolios and whether they are invested in the most attractive parts of the fixed income markets.

Let's start with government debt. The UK has borrowed £215 billion since April (as at 20 November) and £22.3 billion in October alone, which was unsurprisingly a record for the month, to pay for the economic impact of Covid-19. This follows more than a decade of quantitative easing (QE) by the Bank of England (BoE) to encourage spending and investment since the Global Financial Crisis (GFC), mostly through buying government bonds. This is in addition to interest rates being at very low levels for the duration of this period.

This all matters to investors because of the impact this has on bond markets and returns on investment. First, the yields on government debt have tumbled since 2008 because of low interest rates, QE and investor demand for 'safe' assets. This means investors have made good total returns from government bonds over this period but yields now do not have much further to fall even though some countries have experienced negative rates.

Lending the UK government money for a period of 10 years would currently net you a yield-to-maturity (a total return measure incorporating initial investment, interest payments and final loan repayment value) of 0.29% a year. This potential return is low and even lower when you take account of the impact of inflation. Current inflation expectations, using the RPI (Retail Price Index) measure, are for 3.2% over the next 10 years, implying a -2.9% annual real return on 10-year government bonds.

The chart below shows how this compares to a yield that fluctuated in a relatively normal range of 4.0% to 5.5% over the first eight years of the century. The yields from lending to the UK government for a two-year or five-year term are already negative in nominal terms (and even worse in real terms).

It seems logical that bond market prices will fall (and yields will rise towards more normal levels) at some point but central banks still have huge power to control and manipulate markets via bond buying.

Not only are bond markets in aggregate more expensive than in the past but they are also potentially riskier. This is shown by the fact the duration of the Bloomberg Barclays Global Aggregate Index of government and corporate bonds (lending to companies) has increased from around 5.5 years to over 7 years in the last decade. Duration explains how sensitive a bond is to movements in yields; when the interest rate on a bond rises, its price goes down. The higher the duration, the higher the bond's interest rate risk. Modified duration tells an investor the expected percentage change in a bond's price in response to a change in interest rates.

If a bond investor has lower duration than the market average and bond prices generally rise (while yields fall), then their bonds will rise by less; if market-wide prices fall, a lower duration portfolio will fall by less.

Going back to the rise in duration of the Bloomberg Global Aggregate Index, market-neutral bond investors now need to own bonds with an average duration of 7.5 years or risk their portfolios having different interest rate sensitivity than the market average. This means investors are having to take on more interest rate risk to match the index of government and corporate bonds.

We do not advocate investing in fixed income markets in aggregate because of how expensive and risky they are. But this does not mean we dismiss bonds in totality; conversely, we believe there are opportunities for those who actively manage their investments.

Prices and yields for different areas of bond markets will not always move in the same directions at the same time. For example, prices may rise (and yields fall) for short-dated bonds of one year or less to maturity while prices for 30-year bonds fall. Choosing the correct exposure to the yield curve (a graph of bond yields against their maturity) is therefore very important. The same is true of choosing your allocation between government and corporate bonds and your credit risk - which governments and companies you are comfortable lending to at the available yield.

One of the most powerful allocation tools at the moment is the ability to escape the anaemic yield environment of government bonds by strategically allocating money to different areas of the corporate bond (or credit) market. The extra yield an investor gets from lending to a company rather than a government reflects the greater default risk; companies can go bust whereas many developed market governments can print more money to cover loans.

This extra yield is captured in credit spreads. If a UK government bond yields 1% while the average investment grade company (those believed to have the lowest risk of loan default) yields 2.5%, the credit spread is 150 basis points. Corporate bonds that aren't assessed as investment grade are called high yield, they need to offer higher yields on their bonds to borrow money from investors in order to compensate for their higher risk.

For example, we hold Netflix in our Liontrust GF High Yield Bond Fund and its 2030 bonds offer a yield of 3%. We recognise there are credit risks: before the crisis Netflix still invested more cash than it generated because it is growing so quickly, and well-resourced rivals like Amazon, Apple and Disney ensure a very competitive market. Netflix, however, has more than 140 million subscribers who we think have a reasonable degree of brand loyalty. We also view content streaming as non-cyclical; customers will retain their £9 a month subscription during tough economic times, as shown by its subscriber growth during the pandemic. We think Netflix's default risk is low and, if needed, the company could swiftly switch to cash generation mode by toning down its investments.

Investors are facing three challenges in investing in bond markets at the moment - in aggregate they look expensive, there is a lack of yield and they have higher interest rate risk. Despite this, there are still opportunities to take advantage of market inefficiencies and generate relatively attractive levels of income.

To do this, investors need to be selective and flexible when investing across fixed income markets, including corporate bonds. This includes avoiding certain risks at the moment, such as exposure to energy prices, changing technologies or financial sector contagion, and committing cash where they believe they will receive a return that justifies the risk. We will be exploring these opportunities in three future articles.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Tuesday, December 22, 2020, 12:56 PM