11th June 2014
In this interview, Paul Read provides his insight on why bond yields have fallen this year, when central banks will raise interest rates and where there are opportunities in fixed interest markets.
Why have bond yields fallen this year?
There have been a number of contributing factors. Inflation has been lower than expected, particularly in Europe, and the US Federal Reserve tapering (reducing its bond purchases) has been less of an issue for the market, due to the budget deficit falling at the same time.
You mention inflation falling across Europe. Is the European Central Bank (ECB) doing enough to react to that situation?
I don't think it was doing enough in the early stages of the financial crisis or the euro sovereign-credit crisis, but its definitely been more proactive in the past couple of years, since July 2012, when Mario Draghi, the president of the ECB, said he would do whatever it takes to save the euro. The recent package of measures was pretty aggressive, for example negative deposit rates and putting in place longer-term funding (similar to the scheme in the UK). So they are doing moret.
What are your expectations for interest rates in the UK?
Money markets are predicting a modest rise later this year or early next year. Today's unemployment data continues to support the argument that the UK economy is doing well, so I think it's hard to argue with the probability that there will be at least one rate hike before the general election. If you were Mark Carney (governor of the Bank of England), you wouldn't want to do it too close to the election, so maybe you do it in February. However, I don't think we are in for a long series of hikes. I think we are still in an era of quite low short-term interest rates.
What about the US?
I think the situation is similar. The first rise may be a little later than in the UK, but the process of normalisation is under way as they continue to reduce their bond purchases (tapering). I think rates in the US may rise in the first or second quarter of next year.
Where do you see value in bonds presently?
It's hard to argue that mainstream government bonds anywhere are particularly attractive. It's also hard to argue that either investment grade or high yield bonds are cheap. It's really about picking and choosing right now.
Do government or corporate bonds provide the best mix of security and return?
Using the US as an example, the evidence is that, over the long term, investment grade corporate credit outperforms US treasuries because the yield on high-quality corporate bonds is more than enough compensation for the relatively low default rates (non-payment by companies). Compounding over time, it's quite powerful.
Now I think it's important to caveat that the corporate bond market is evolving. It has grown massively and has deteriorated in credit quality over the past 20 or so years, so there are not that many top-quality corporate credits any more. So, there has been some increase in risk.
What is your current approach in terms of duration (how long before a bond is repaid)?
In broad terms, we tend to run lower-duration portfolios most of the time, and this year is no different. The Invesco Perpetual Corporate Bond fund is running at around 4.4 years and the Invesco Perpetual Monthly Income Plus is running under 4 years.
How much liquidity is there in bond markets (ability to buy and sell bonds)?
Part of the reason we have a lot of liquidity in our portfolios, is that liquidity in our markets could dry up just when we need it. If you think about what has happened over the past eight years, investment banks have been under pressure to reduce assets and shrink balance sheets. There is less and less interest in having significant amounts of inventory, and the bond markets, by and large, are 'over the counter' markets. So, when we want to sell something, we call a broker and ask for a price, and if he is reluctant to buy the bonds himself, he has to find someone who will. It means there will be pressure on the price and very little liquidity, or in other terms, it will be difficult to sell. We saw this in May last year, when emerging market bonds reacted to the US Federal Reserve saying they would slow their bond purchasing programme. So we have to be prepared.
Can you summarise how you are feeling about your markets for the rest of this year?
I'm sanguine. I think that we are in a low-yield, low-inflation environment, where there are now slightly conflicting central bank agendas. The US and the UK may raise interest rates, while Europe, may increase its forms of quantitative easing. Having said that, there will probably be a reluctance from any central bank to be too aggressive.
My message to investors is to manage expectations. If you take no risk in these markets, there is no return. You get zero, or almost zero, on bank deposits and you get the same from short-term government bonds. We will still be a relatively safe provider of income, but are managing expectations about the return potential for my asset class.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Paul's views are his own and do not constitute financial advice.