Bond durations have been pushed out to an average of nine years across client portfolios at Thesis, with chief investment officer Michael Lally warning of a squeeze on short-duration securities.
In addition to ultimate responsibility for Thesis’s £4 billion of private capital, Lally is also manager of the Thesis Optima Bond fund, which over three years has returned 28.56% versus the IMA Sterling Corporate Bond sector average of 22.80%.
‘We think bonds are a safe place to park your cash for at least the next year, but beyond that we think the short end, particularly investment grade, looks expensive,’ says Lally.
‘We have an average duration of around nine years, versus average fund duration of four or less. I am not worried about inflation because it has been commodities, not wages-based. There is nothing that would suggest we are going to experience an inflationary spiral – it’s a China syndrome.’
Too many models were producing outputs pointing to a simple reversion to mean, Lally says, without factoring in how much the mean had been shifted by excess capacity and credit market disruption.
‘The problem with precedent is that, as with case law, it is constantly being rewritten. We find ourselves now in a unique position, whereby, thanks to the global synchronisation of central banks, even fast-growing emerging economies such as China and Brazil have managed to keep their inflation rates down to single figures.
‘Meanwhile, tighter regulation of most banks has severely restricted both their ability and willingness to expand credit supply.’
Given the house’s median view of a moribund economy, he says yields of 4.5% a year over a nine-year term seem a reasonable rate of return, versus short-dated bonds priced at a loss to maturity.
‘For a long time we were effectively facing a flat yield but it has now steepened sharply. You weren’t getting paid for duration but if you can’t see much inflation on the horizon, it now makes a lot of sense.
‘[At current values] the only way you can make money on short duration is derivative structures. At some point you are going to get a whole rush of distressed buyers flooding into [long] duration.
‘And long-dated issuance by corporates is only just getting started. If chief financial officers can lock in these funding costs over 20 years, why wouldn’t they? It’s like Christmas has come early.’
With the short to medium-term outlook dominated by policy risk, he adds that in the absence of inflation, it is hard to see where downward pressure on bond pricing is going to come from.
This could partly explain recent underperformance on many fixed income hedge strategies, with managers caught in a short squeeze as risk aversion moved against them.
‘I think a lot of people went long equity risk and short gilts, which has been a very volatile trade,’ says Lally.
While pushing out duration over the course of the year, the company has steadily sold out of almost all its gilt holdings across almost all of its risk-rated portfolios.
Instead, it has taken global sovereign exposure, using the Pimco Global Absolute Return fund to balance costs and liquidity with a healthy amount of exposure to emerging market debt.
While sceptical about the more apocalyptic end of inflationary expectations, the company has also diversified into global inflation-linked securities via funds such as Thames River Global Bond, although he says that over the shorter term, managers Paul Thursby and Peter Geikie-Cobb mistimed several calls and are currently ranked 58 out of 60 in Citywire’s Bonds – Global sector.
‘We recognise that different countries have different drivers of inflation. We are not expecting any form of inflationary shock but with rates near zero, even 2% to 3% inflation offers a decent return,’ he says.