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Out in the cold: unloved bonds face battle to remain relevant

Out in the cold: unloved bonds face battle to remain relevant

While one bond franchise is stirring, another is shaking. Spectre, the latest in the James Bond film series, has taken in £600 million at the box office since its release in late October. That amount and half again, £919 million, was withdrawn from bond funds the following month.

Even allowing for the price of popcorn, it is unlikely all of that liberated bond money went towards seeing the rather less liberated Bond. Can the bond industry, like its Pinewood namesake, rediscover its verve?

Ominous outflows

November’s outflow was not an anomaly. In the first 11 months of 2015 (December’s figures have yet to be released by the Investment Association), a net total of £4.5 billion was redeemed from fixed income funds.

That has not all come from riskier high-yield funds, either. Although market turmoil in August prompted a net £308 million investment in gilt funds, £424 million was pulled from the sector in the following three months.

The explanation is not widespread optimism about equities. Anxiety heading into 2016 has been vindicated so far by a torrid start to the year, with the FTSE All Share dropping 7.8%.

Against this backdrop, bonds performed well. The Barclays Sterling Gilts index has gained 2.5% in the nascent year, while the broader Barclays Sterling Aggregate Non-Gilts index is up 1.0%.

If August was any barometer, many will have jumped back into gilts as a safe haven. But if the subsequent period of last year is an indicator, more will make a swift exit from the sector soon enough.

Unbreakable bonds?

What role do traditional bonds play in portfolios now? Are they merely a life jacket only to be used in emergencies? Or, as in standard portfolio theory, should they be ever-present?

Kasim Zafar, portfolio manager at EQ Investors, is not interested in traditional bond exposure in the current environment. ‘There are no parts of the market where we can build enough conviction for a long-term strategic holding,’ he said.

Zafar instead uses ‘flexible bond fund strategies’, particularly those employing derivatives to ‘neutralise various risk factors of bonds’. He complements these funds with absolute return strategies and commercial property to ‘control portfolio volatility and capture different risk premiums’.

David Rouse, principal financial planner at Friar Gate Independent Financial Services, outsources investment management and is happy to see fixed income allocations in portfolios.

‘I think bonds will continue to play a role for risk-averse clients,’ he said. ‘They are there for diversification.’

Rouse said bond exposure did not have to be limited to gilts in portfolios, and his providers had not used government bonds for some time.

‘The bond market has opened up in the past few years because of the perception valuations of UK gilts and corporate bonds are too high,’ he said. ‘The market has incorporated a greater range of foreign bonds to try to find value.’

Correlation conundrum

Correlation is a consideration for safety, too. Simon Glazier, head of wealth services at Aberdeen-based AAB Wealth, has used the Vanguard Global Bond Index fund for several years.

‘That has done well and given us good returns, but we now realise it is doing clients a disservice,’ he said. ‘Bond funds should be the low-risk element, but the longer duration and more junk-like bonds are giving more of an equity experience.’

Glazier is therefore shortening duration and raising credit quality in portfolios, while planning to move to the Vanguard Global Short Term Bond Index fund and continuing to use the Dimensional Global Short Dated Bond fund. ‘Dimensional’s view has been bond funds should be a safety net,’ he said.

Glazier typically allocates 30% to 40% of portfolios to bonds, but would go no higher than 80% in fixed income, even for the most cautious.

‘You need a bit of equity content to give you a hedge against bonds falling,’ he said. ‘The evidence of the past 20 years is that you actually get poorer returns but without taking less risk. You get less risk by having some equity content.’

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