Weekly Digest

Searching Further Afield

Michael Clough

08 July 2019

There are not many news articles I read two years ago that I can still remember. There is one though that has always stuck in my mind and it was titled ‘Are we headed for a bond market bloodbath?’1. At the time the yield on the US 10 year Treasury was 2.5%, the UK 10 year gilt was offering an uninspiring 1.2%, whilst the German equivalent was giving you a frankly unattractive 0.4%. Today the yields in all three of these regions are below what they were in 2017. This extraordinary period of ultra-low bond yields has continued. In fact since October 2018 we have witnessed bond yields plummet further. With several high quality fixed income assets now offering negative real returns (and some even in nominal terms!), investors have had to look elsewhere and reach out for yield. Whilst the prospect of higher yielding assets is appealing in the current interest rate environment, reaching too far and taking on too much risk could come back to haunt investors.

As at the end of last week, lending money to the German government for 10 years would grant you a -0.36% annualised return. You would have to push out beyond 20 years to earn a positive return assuming you held the bond to maturity. Now, there is an Austrian government bond today which matures in 98 years time and for that time horizon you might expect quite a healthy return. The reality; a discouraging 1.1% per annum. You would have to bear over 50 years of duration risk too, so any rise in interest rates is going to be painful.

The above illustrates just how unattractive a number of typically defensive markets are today. An option for investors is to instead opt for investment grade or high yield corporate bonds. However, these are not exactly a screaming buy at current valuations. They also carry greater default risk. Whilst we do have some exposure to such credit strategies in Momentum portfolios, we have also looked at alternative opportunities available to us.

In May, we initiated a position in an asset backed securities (ABS) strategy and in June we added to a strategy investing in private infrastructure debt. Both offer attractive yields, but your first question will likely be ‘Are these not adding significant risk to your portfolios?’. We don’t think so. Both strategies are investing in more specialist bond sectors and provide an illiquidity yield premium, however, they are structured as closed ended investment trusts which allays the bulk of this risk. Both are managed by two focused boutique firms with vast experience managing these asset classes. We have faith in these managers to identify the most attractive opportunities in their respective markets and minimise downside risks through careful issue selection. Finally, both strategies provide exposure to principally floating rate debt. As such (rising) interest rate risk is reduced. It is important to say these strategies will never form a large part of our portfolios. As small allocations though, they give us greater diversification and introduce additional return drivers to the portfolios.

In a world of low bond yields, investors must search further afield for good value opportunities. Whilst more niche areas of the market offer better rewards they rarely come without additional risk. Our extensive due diligence process, which we subject all our managers to, has allowed us to build confidence in these newer bond strategies, but we have rejected many more in the recent past. Now all I’m left thinking is will anyone remember reading this in two years’ time. I’ll live in hope. Perhaps I should have gone for a more sensationalist title instead…

1 BBC News. 20/03/2017

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