Fixed income becomes even harder to navigate

0

Stay informed with free updates

Never invest in something you do not understand, as the adage goes. For wealth managers, the fixed income market has always been tricky to explain — but with recent changes in inflation, it is getting harder. 

It is even more difficult still for investors to adjust to the current state of the bond market, which has gone through three distinct periods in the past 15 years. In the aftermath of the 2008 crash, yields sat at all-time lows and were not expected to go any lower. But then Covid hit — prompting waves of stimulus from central banks, causing inflation to shoot up and interest rates to rise rapidly.

The resulting sell-off in bonds led to bondholders swallowing “horrible, equity-like losses,” says Ben Seager-Scott, chief investment officer at auditors Forvis Mazars. “This unfortunately meant that the lowest risk investors took the most pain in their portfolios . . . that was really uncomfortable,” he says. 

Post pandemic, as inflation began to come under control, investors began to be more sure of the future for fixed income. But then, again, a surprise came in the past few months with several developments that may push inflation up. “Now, at the end of the year, with Labour [in the UK] borrowing a lot more than people thought . . . and Donald Trump winning in the US . . . [these are] likely to lead to stickier inflation and higher interest rates in the long run,” says Ryan Hughes, managing director at AJ Bell Investments.  

Market participants are realising that the flat, low, predictable rates over the past 15 years were an anomaly, and the market is actually returning to what it was like before 2008.

Popular bond funds

Source: most popular bond funds in the past 12 months on AJ Bell’s platform

“We’re now in this third phase, which is trickier to predict . . . you have to be much more choosy in terms of where you go in the fixed interest market,” Hughes adds. It means a boom in demand for advice about the bond market. “If you are a fixed income investing expert you are a hot commodity right now,” says Seager-Scott.

So where to start? Investors should start by understanding exactly why they want to hold bonds, wealth managers say.

The use of bonds can be broken down into three categories. Firstly, bonds can be used by investors requiring a higher level of income, through investment into higher-yielding parts of the market. The second use is the more traditional position in a multi-asset portfolio, where fixed income provides diversification against growth shocks. The third is for those who are moving out of cash but do not want to invest long-term — they are able to lock in a slightly higher return than interest rates through the bond market. 

There are other reasons to invest in fixed income, especially for UK-based investors. UK government bonds (“gilts”) are currently exempt from capital gains tax, meaning that any gains on the value of the bonds do not count towards investors’ CGT allowance. 

But wealth managers caution investors about certain parts of the market which are seen as risky, including company debt. “The cyclical nature of credit means the risk of a company defaulting tends to be correlated with economic cycles,” says Seager-Scott.

It is also worth looking closely at “inflation-linked” bonds, which were popular when inflation started to rise — understandable given their name. “A lot of people bought these because they saw inflation becoming a problem and thought, ‘oh if I buy these they make me immune’,” Seager-Scott says. “But that was to the detriment of many . . . [because] you are taking a view on what [you] think will happen [to inflation] versus what is priced in.” This type of strategy is complicated and can come unstuck very quickly.

Other possible derailments could come in the form of duration risk. “Duration changes in the market and the interest rate risk today is definitely greater than it was a year ago,” Hughes says. 

But the final frontier remains the complexity of bonds. While they tend to be a lower risk investment, they require a lot more explaining, says Ben Kumar, head of equity strategy at wealth manager 7IM.

This is particularly the case when clients are able to log into their portfolios and see bonds’ mark to market — the daily market value of the bonds they hold.

“There is this perception of bonds as part of a risky investment world which I think is broadly untrue — it’s almost easier to persuade someone to invest in equities than it is in bonds,” he says.

“Bonds are a great tool for a retail investor, but . . . quite difficult to get their heads around.”

#Fixed #income #harder #navigate

Leave a Reply

Your email address will not be published. Required fields are marked *