BONDS: Long-term outlook? Don’t ask

Bond managers have had a great deal thrown at them. The latest is the US downgrade. Fiona Rintoul asks investors what to expect and finds few are in the mood for predictions.

To say that future developments on the global bonds markets are hard to call at the moment is to understate the case considerably. Nervous laughter greets requests for a long-term outlook. 

“This is an extraordinarily tough environment,” says Jim Cielinski, head of fixed income at Threadneedle. “Risk and volatility are so high because of policy risk. It does make for a lot of real challenges.”

Life for bond (and other) fund managers, has been tricky since the 2008 global financial crisis. We perhaps all suffer from a certain low-level anxiety, knowing that that crisis was ‘solved’ in an unsatisfactorily interventionist way, and that such things do tend to come home to roost. But matters really started to get complicated on the bond markets a couple of months ago. 

“A big theme of ours for a couple of years now is favouring credit risk over interest rate risk,” says Jenna Barnard, director of retail fixed income at Henderson Global Investors. “That hasn’t changed hugely since the beginning of 2009, but since mid-April this year the picture has got a lot murkier.”

Now we are truly in uncharted territory. US sovereign debt has been downgraded from AAA by the rating agency Standard & Poor’s, while in Europe panic over whether governments can continue to service their debts is spreading from the so-called peripheral markets of Greece, Portugal and Ireland to larger markets such as Italy and Spain. No one seems to be able to stop the contagion, calling into question the entire Eurozone project and making the unthinkable – the end of the single European currency – thinkable. 

Of course these problems have been brewing for some time. That’s one reason why strategic bonds funds, which can allocate more or less freely (strategic bond funds come in a wide variety of different guises) among the different bond sectors, have enjoyed a surge in popularity recently. 

And you could argue that the likes of the US downgrade is largely symbolic. 

“The timing was painful, occurring after one of the worst weeks in several years, but we do not believe the change itself is overly significant,” says Cielinski. “S&P do not determine credit risk, they merely opine on it. The downgrade is a response to the debt crisis and not a cause.” 

The US downgrade and the escalating problems in Europe perhaps just make a difficult job – achieving sensible bond allocations – even harder. As Cielinski says, “While the downgrade does create greater uncertainty and fear in the markets, it is a sideshow compared to the more fundamental drivers of asset prices, namely growth, inflation and the lack of plausible policy responses to today’s crisis.”

This lack of plausible policy responses has been enough to put some strategic bond fund managers off developed-market government debt altogether. Indeed, the fact that sovereign debt prices in the developed world are being driven to such a large extent by politics is seen as problematic in and of itself. Even if fund managers were impressed with the policies, which they aren’t, the fact that the market is being manipulated by politicians is – how to put it? – sub-optimal.

“We’ve become political analysts,” says Fatima Luis, manager of F&C’s Strategic Bond fund. “It’s hard to have a long-term view. The long-term view is that things will be difficult.”

Luis prefers to stay away from US and developed Europe sovereign debt “until there is more guidance on a resolution”, and she is not alone. 

“Developed market bonds and cash offer low returns, and interest rates are more likely to rise than to fall,” says John Stopford, co-head of global fixed income at Investec. “In the short run, there is the US debt question and ongoing uncertainty in Europe.”

This raises the question: is there value in the global bond markets and if so where does it lie? Talking to strategic bond fund managers two broad preferences emerge: high-yield corporate debt and emerging-market debt.

Emerging-market bonds used to offer higher yields than developed-market bonds, but with greater risk. Now, against a backdrop of developed European markets effectively going bust, emerging-market bonds are seen by their proponents as offering higher yields with less risk – or certainly no more risk – than developed market bonds. 

“The relative quality and risk of developed versus developing markets is going through a fundamental change,” says Stopford.

While interest rates in developed markets are at an all-time low such that the only way is up, interest rates have stayed high in the emerging markets. And, as is the case on the equity side, fund managers who favour emerging-market bonds point to the better economic fundamentals and policy-making in the developing world. 

“[In the current environment,] you need to stick with what can do well under almost anything you throw at it, and top of the list is emerging-market bonds,” says Cielinski. “Emerging markets can’t decouple forever, but they are in control of themselves, whereas Italy and so on are not.” 

Seeking safe havens
This has led people to diversify away from the majors, says Stopford. “It’s a fear trade. People are overexposed to the places with the biggest problems. Increasingly, emerging market debt offers a relatively safe haven or something to diversify into that offers more possibility for growth.”

Not everyone agrees, however. Most strategic bond managers see value in high-yield corporate bonds at the moment, which could do well in a low-growth environment, even if, as Stopford points out, they’re “not as cheap as they were”. But the likes of F&C’s Luis favour developed-world corporates, such as US high-yield, over emerging market corporate or government debt.

“Emerging markets corporates are quite expensive versus other markets,” she says. 

Luis is targeting BB corporates, particularly existing holdings and names she is comfortable with. Similarly, in these uncertain times, F&C’s Barnard is looking to BB corporate debt for value, while diversifying into the safe haven of Bunds, gilts and treasuries as a hedge. 

“We see pockets of value in the corporate bond market but we are very picky and focused on quality,” she says. “We didn’t invest much in this year’s issues.”

Meanwhile, Andrew Craig, investment specialist fixed income at BNP Paribas Investment Partners, manager of the Parvest Bonds Euro fund, which invests strategically in the eurobond market, has concerns about the current vogue for emerging-market debt. 

“Emerging market debt is attractive and much talked about,” he says, “but we still think there’s a lot of political risk in emerging markets that may come back and bite people.”

Cielinski counters that, while it’s true that there is political risk in emerging markets, political risk is generally highly correlated with economic stress and, that being the case, is not any greater in emerging markets than within the Eurozone. 

Craig, however, is not yet ready to write off his home turf of the Eurozone. He takes a much more positive view of its future – even on the periphery – than do most global strategic bond fund managers. “We tend to be quite constructive on growth in the Eurozone. We think the market is extrapolating too much negative impact on growth from the current crisis.”

Thus, Craig does not subscribe to the apocalypse theory for Europe’s most heavily indebted nations, believing that growth will allow them to get out of their current situation. Accordingly, his portfolio is therefore overweight Italy and was overweight Portugal, but is now neutral, and he has an off-benchmark position in Greek debt. 

Other strategies that Craig is pursuing are overweight positions in covered bonds, which “provide protection in an environment where private debt holders are tied into the restructuring of government debt issues” and inflation-linked bonds, since he believes the market has underestimated inflation risks. Craig’s fund is also overweight agencies and supranationals, where there has been a lot of issuance this year and which are attractive to hold “in these time of uncertainty vis-à-vis government issues”.

No return without risk
By contrast, some global strategic bond fund managers are targeting what might be termed the safe European fringe. Thus Stopford is overweight Norway and Sweden, as well as the non-European fringe markets of Australia and Canada. 

With Europe and the US in crisis, and the world economic order in a state of flux, the long-term picture on the bond markets is extremely hard to call. In the short term, a wait-and-see strategy may make sense.

“We are maintaining a high cash level given the macro situation,” says Luis. “Markets are quite illiquid at the moment. In moments of volatility it pays to keep your powder dry.”

In the medium term, managers broadly see value in quality corporates and emerging markets, but prefer shorter durations due to the many prevailing uncertainties. But perhaps the main theme in today’s global bond markets is that in what has traditionally been looked on as a safe asset class there is no return without risk.

“The really safe things don’t offer any return or yield,” says Cielinski. “For a lot of people the right approach is to lower their return expectations, but they don’t want to do that.”

©2011 funds europe



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