Bond manager recommends equities! … And absolute return bond funds

From
Tim Haywood

Tim Haywood

With expectations of rising interest rates in most major markets, bond funds with the longest dated bonds are looking increasingly risky.

In fact, according to one leading global fixed income manager, Tim Haywood, long-only investors may be better off in equities, especially after the recent cheapening. For investors with more latitude, a fully unconstrained fixed income strategy incorporating shorts as well as selected longs has increasing appeal.

Mr Haywood is an investment director and lead manager of the GAM Investments Absolute Return Bond Fund (ARBF), based in London. He made his comments ahead of his next scheduled trip to visit Australian clients in March. The ARBF has a long track record of producing solidly positive returns in markets when interest rates are rising, as well as making money when rates are falling.

“The bond market is under pressure from so many angles that you need the capability to take advantages of all opportunities,” he says.

Beyond being short duration, these opportunities include convertible bonds with equity protection, selected investment grade credit and high yield credit matched with credit index protection, and foreign exchange overlay with effective stop losses.

“Equities have done pretty well, although some markets had become fully priced; the recent declines are a healthy correction, as of 6th February, on the assumption that the growth and optimism continue. I may be one of the few fund managers in the world who has been promoting to those who can only buy securities, to buy something else, as opposed to being permanently optimistic for the asset class I represent,” Mr Haywood says.

Government bonds remain expensive, yet intermittent rallies will be too lucrative to ignore, he says. Traditional corporate bonds have their best days behind them, even if most corporations are thriving.

GAM has identified eight key problems with the bond markets:

1. Headline inflation is rising in most parts of the world. GAM is predicting that wage inflation will creep higher.

2. The starting level of yields is important for the period of measurement. For instance, the worst-performing country in fixed interest last year was Germany, even though that economy is thriving. The problem is Germany started from a position of negative yields at the end of the previous year. When adjusted for future inflation, the starting yields generally look even worse.

3. Emergency low interest rate policies are being rowed back. The US Federal Reserve is likely to hike rates and more officials in Europe are pressing for a return to “normality” of modestly positive deposit rates, Mr Haywood says. “It’s important to get to that point before the next recession.”

4. The big bond-buying programs, under Quantitative Easing (QE), are coming to an end. “The main one for us is Europe,” Mr Haywood says. “For every year of the QE’s operation in Europe, they have bought seven years of net production of government bonds. It’s really been like a big vacuum cleaner.”

The answer to these first four problems, GAM believes, is to be short duration in its unconstrained fixed income fund and portfolios.

5. The difference between long-dated bonds and short-dated securities is very “skinny”. In the US, for instance, the difference last week between two-year bonds and 10-year bonds, for 2020, is only 15bps. “You are not getting paid to take more interest rate risk,” Mr Haywood says. “No-one is satisfied that the bonds they are buying are pay high income or will perform brilliantly in an equity collapse. People have to do new and interesting, sometimes dangerous, things to boost their income.”

6. A further challenge for bond funds, like GAM’s, Mr Haywood admits, is that credit spreads on traditional bonds have become tight, making it more difficult to exploit credit as most have successfully done for the past five years. The all-in yield for new debt is very low, so lots of companies are issuing long dated bonds, often to finance M&A activity or share buy- backs. “This may be a treasurer’s dream, but the flip side of that is a fund manager’s headache,” Mr Haywood says.

7. For most of the last 12 months, until February, there has been very little volatility in financial markets, as bonds and equities rose. Passively managed long-only investments have looked like a smart idea, Mr Haywood says. When those market prices fall, fully-invested long-only passive funds don’t seem like such an obvious choice. “In January, for the first time in a couple of years, many hedge fund styles made money.” For absolute return funds, such as the ARBF, January was also a noticeably good month across the peer group. GAM took the opportunity to increase protection via buying options. In early February, those who shorted volatility seem to be suffering.

8. Finally, there’s the equities story. The spectre of rising interest rates finally hit home in the US since last Friday – and Australia this week – with the AS30 index coming off about 5 per cent. While this may probably prove be only a temporary correction, triggered by the impervious march higher of bond yields. “Volatility has woken up, asset prices are generally declining, which may eventually hurt certain risk parity offerings. The US dollar decline has paused, especially versus the Aussie dollar: it’s become very different in some corners,” Mr Haywood says. “But away from screens, key forces remain robust, and for that reason, equities may yet show good returns in 2018.”

In late January, the ARBF sold four of its most equity-sensitive securities and moved to a more balanced portfolio. It also increased its protection against a drop in equity markets and took the total duration of the portfolio, which had been “pretty negative”, back to zero.

Mr Haywood says that absolute return bond funds represent a more appropriate way to now achieve the main attributes normally achieved by buying bonds, which are to preserve capital, provide safety in times of stress, provide for a reliable income stream and to provide uncorrelated returns compared with equities and property.

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