Bond funds continue to play the duration game

Here we go again. No sooner does market action start to take a distinctly deflationary bias than a major central bank pipes up with some fresh monetary stimulus, or at least starts to drop some awfully heavy hints in that direction. European Central Bank President Mario Draghi appears to be considering an increase to the Eurozone’s €1.2 trillion Quantitative Easing (QE) programme, and even negative interest rates. China has just cut its headline borrowing costs for the sixth time and encouraged banks to lend by cutting the Reserve Requirement Ratio and the amount of capital lenders must keep on their balance sheets.

Whether these moves achieve their goal and boost both global growth and inflation remains to be seen, while investors will also want to see whether the financial markets’ decide these initiatives are welcome or not. Their immediate reaction was positive, as equities rose, bond yields fell and the third-quarter’s weaker performers, such as emerging market currencies and stocks, as well as Western junk debt, rallied hard.

This again leaves us all with a dilemma. As described in this column several times before, the irresistible force of underlying market action still appears deflationary, as global growth slows, yet the immovable object of central bank policy is geared toward the creation of inflation, with the phrase “QE4” now entering some commentators’ lexicon, as they weigh up scenarios which could lead to Janet Yellen and the Fed loosening and not tightening US monetary policy in 2016.

As such, investors will need to prepare for a wide range of possible end-games and seek to maximise the protection and value offered by a diversified portfolio. Fixed-income could have a role to play here, as a source of income, in the form of coupons, and also ballast should a deflationary scenario come to pass. Many investors will worry yields are too low to compensate for the risk of a future inflationary spike and this is where bond fund selection could be so important. 

As an example, this column recently met Paul Causer, co-head of the fixed-income team and fund manager at Invesco Perpetual. It is instructive to look at the asset allocation across the four funds for which he is responsible.

Investors can pick from a range of durations and yields to find a bond fund which may fit their goals and needs

Source: Invesco Perpetual, as of 31 August 2015. *Liquidity defined as cash, government bonds and bonds with less than one year to maturity.

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Compare these moves to say Ian Spreadbury’s Fidelity Moneybuilder Income or M&G Optimal Income, run by Richard Woolnough and the team there. 

Investors can pick from a range of durations and yields to find a bond fund which may fit their goals and needs

Source: Morningstar, as of 23 October 2015. 

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Which of these bond funds (if any) suits an investors’ portfolio will entirely depend on their own personal circumstances and view of the world. Looking at how the funds are currently positioned, Fidelity Moneybuilder may be better suited to a deflationary scenario, M&G Optimal Income and Invesco Perpetual Bond to an inflationary one, with the latter having a heftier weighting toward investment grade and a plumper yield. It will also be interesting to see how (and when) Causer begins to deploys the cash that lies within Invesco Perpetual Tactical Bond but there will be no one-size-fits-all solution for those investors who believe some fixed-income exposure suits their strategy, target returns, time horizon and appetite for risk.

This column will continue to try to shed light on bond funds’ strategies but ultimately investors must do their own research when it comes to fund selection, whether they are looking at fixed-income and any other asset classes and geographic markets, so they are in a position to pick the collectives which best suit their own specific personal goals and portfolio requirements.

Russ Mould

AJ Bell Investment Director