Bond markets have had a testing few months, with assets selling off in the wake of rising yields as the US 10-year Treasury yield exceeded 3% for the first time since 2018 at the tail end of April. This had a knock-on effect among equities, with growth stocks especially falling in response. Indeed, the US Nasdaq 100 index has suffered its sharpest falls since 2020, the last time this bond-equity dynamic played out.
In response, both the Bank of England (BoE) and US Federal Reserve announced watershed interest rates hikes to try and tackle inflation. The former raised rates by 0.25%, putting it at the highest level since 2009, and the latter increased rates by 0.5% for the first time since 2000.
Jeff Keen, director of fixed income at Waverton and manager of the Waverton Global Strategic Bond and Waverton Sterling Bond funds, said that these hikes were just a “blunt tool to cure inflation,” since some of the drivers are out of central bankers’ hands, specifically, the war in Ukraine spiking energy prices and longstanding supply chain issues.
Despite this, Keen said central banks had “no alternative” to do anything other than raise rates and continue with tightening “even though I think that will start to have a difficult economic impact because they have a particular mandate to control inflation”.
Indeed, Andrew Bailey, the BoE’s governor, admitted as much in his address last week, stating that the UK was walking a tightrope of tackling inflation and avoiding recession.
Keen said: “That that kind of delivery message is something that people told me could never happen.”
When it comes to recession, Waverton’s Asset Allocation Committee, of which Keen is a member, estimate that there is a 25% of recession and 60% chance of a slowdown in growth.
“For us as bond investors, that’s an 85% chance of some degree of slowdown. So that is what we are getting ready for,” he said.
Within his funds, Keen has deployed a “cautious” approach, reducing duration on credit and short dated bonds while loading up on government bonds, with the latter delivering a negative correlation to equities “if we go into a crisis, the same way they did during the early Covid sell-off”.
He said that if it was “100% certain” that markets were going to into an extended slowdown or recession then selling down credit completely and going “100% government bonds would be the right call, but we never know for sure how the markets may turnaround”, hence he was keeping some “dry power” back in case the outlook changes.
Although inflation is taking up the lion share of managers’ attention, the Ukraine-Russia war also demanded attention.
Bryn Jones, manager of the Rathbone Strategic Bond fund, said he had moved to an underweight in emerging market exposure (0.7%) once Russia started putting tanks on the border, a total reversal of the “big position we took post pandemic”, back when he saw a “huge amount of value there”.
The Rathbones manager said that for the first time in five years he was considering buying his own fund, “which I think, is a good indication to investors that this is not the time to be cutting fixed income”.
Within the Rathbone Strategic Bond fund, it was underweight duration in gilts and linkers “as yields rise” but was overweight investment grade credit as “default risks were priced too high”, Bryn said.
Overall, the fund’s biggest exposures are UK corporate bonds and global high yield bonds, with a marginal overweight in the latter via special situations and “legacy banks”.
For those entrenched in credit, Fraser Lundie of the Federated Hermes Unconstrained Credit fund, said that the main problem fixed income investors are facing is the overall uncertainty, meaning a “balanced, prudent, nimble approach” was “very important”.
For him, this involved “stretching the spectrum of fixed income”, looking for diversification outside the ‘go-to’, core areas from the past 10 years because at a time when investors “need every bang for your buck,” they needed to get comfortable with the idea of not just holding what worked the past ten years.
This had led him to emerging market debt, high yield, leveraged loans, structured credit, Asset-Backed Security (ABS), collateralized loan obligation (CLO) all allocations in the Unconstrained fund because “these things do not move in exactly the same way all the time, injecting some of diversification and decorrelation,” said Lundie.
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