Bonds are back on the table as value emerges
The first half of 2022 was a bracing period for investors, with equity and bond indices registering...
Bonds have a reputation for being rather dull. They would be the dinner party guests that everyone desperately tries to avoid getting stuck with at the table.
While equities are perceived as being exciting assets that can easily soar in value on positive news, bonds are regarded as being lacklustre in comparison. Even their biggest cheerleaders concede there’s an element of truth in this opinion, although that doesn’t mean they can’t play an important role in an investor’s portfolio.
Chris Bowie, manager of the TwentyFour Corporate Bond fund, agrees bonds deserve the dull tag most of the time – but insists this is one of their virtues. “They normally pay their interest as it falls due, with no drama or fanfare, and support the income requirements of most investors around the world,” he told us.
He sees the benefits as: secure and steady income streams; potential for capital gains; diversification or lower correlation from other assets; and an ability to match long or short-term liabilities. “There is also the opportunity to encourage more sustainable investments by rewarding those companies and governments that are doing the right things,” he adds.
He’s also keen to point out that not all bonds fit snugly into the safe and secure category. “Investors can also dabble in higher risk bonds which can potentially pay much higher rates of interest,” he says. “However, they very much come with drama and fanfare – and just as equally can default or miss interest payments as well.”
More broadly, Chris loves combining “rational, logical factors”, such as the maths and credit work behind bond markets, with the more emotional human factors. He points out that these include the fact that lending decisions come down to whether you believe the borrower will pay back the capital, with interest.
Interestingly, Chris uses the skills picked up in 30 years of bond investing to get a deeper insight when interviewing leading chief executives and chief financial officers. “Often the softer body language from the borrower is as important as the hard numbers from analysing financial statements in deciding whether bond holders will get their money back,” he says. “The love for me is marrying the two.”
Noelle Cazalis, co-manager of Rathbone Ethical Bond fund, is fully aware of how bonds are perceived by others in the asset management industry. “In my birthday cards, my equity colleagues would write ‘one more year, one more basis point’,” she tells us. “It’s time to get my own back!”
She starts with a straight comparison between these two asset classes. “With equities, when you analyse a company, you have two choices: buy the shares because you like it – or don’t buy them because you don’t like it.”
However, life is very different in the bond universe where she sees a “multitude of possibilities” when it comes to investment decisions-making. “You can buy the more senior bonds or the subordinated bonds if you have more conviction,” she says. “You can also buy bonds from different entities of the same group that will trade differently, and have different covenants attached.”
From an investor’s standpoint, however, Noelle believes the number one benefit provided is income predictability. “When you buy a fixed rate bond, you know how much income you will receive, unless the company defaults, of course,” she says.
This was a reality brought home during the peak of the Covid-19 crisis, when dividends were cut across the board. “It reminded investors that the only way to know how much income you’ll get, is to buy bonds,” adds Noelle. “As a result, fixed income funds saw good inflows, as investors had to deal with the uncertainty of their dividend being paid.”
Harry Richards, co-manager of the Jupiter Strategic Bond fund, describes the sovereign bond arena as “the plumbing” of the financial markets. “It can be hugely informative with regard to the current macro-economic environment and outlook, providing insights into monetary policy expectations, growth, inflation and the business cycle which are powerful when managing any portfolio,” he insists.
To illustrate his point, Harry says a flat yield curve has predicted numerous recessions over the years, even managing to pre-empt the pandemic-induced recession. Of course, while getting the macro right can be hugely profitable, it’s also important to get the bottom-up credit selection correct. This requires thorough analysis to be carried out.
“Working with a phenomenal team of credit analysts to uncover the gems within the market, as well as dodging the bullets, is hugely stimulating and a key driver of alpha,” says Harry. He cites EnQuest, a North Sea oil and gas producer, as a prime example. “This was one of our top high yield picks coming into this year,” he says. “So far, it has returned 39% – hardly boring!”
Overall, Harry insists that bonds and bond funds are a valuable tool for asset allocators when it comes to portfolio construction. “They offer a diversified return profile with consistent income and modest volatility,” he explains. “If used correctly, they can vastly improve your efficient frontier or risk/reward profile.”
He also points out that the “less spicy parts of the bond market” serve a useful purpose. “They become very valuable particularly in later life when drawdowns or equity market volatility may not be appropriate and a need for income in retirement is front of mind,” he says. “For those investors, dull is very much a synonym for ideal.”