David Roberts, fund manager at Liontrust, shares his views below.
Myth #1: The bond market is small and illiquid
Nonsense. The global bond market has a value of roughly US$130 trillion dollars – almost 100 times the market cap of the FTSE 100. True, there are plenty of small, illiquid and unlisted bonds out there, and when anyone wants to rubbish debt as an investment, that’s what they focus on. However, invest in core, large, liquid and listed bonds and it’s possible to buy and sell tens of millions of dollars, euros or pounds in seconds to any one of dozens of counterparties.
Myth #2: You can jump on the Quantitative Easing bandwagon and ride bond prices higher
For nearly a decade, central banks pretended we were in a crisis. They manipulated bond prices – in part using quantitative easing – pushing prices ever upward. It has been a wild ride, with many investors making fortunes. But now, thanks to Covid-19, we have huge fiscal stimulus too; governments around the globe are falling over themselves to spend, spend, spend.
In many ways, this is great and probably should have happened sooner. However, the more fiscal spending there is, the greater the chance of economic recovery. And if you are the one left holding the bonds when the QE music stops, there might be tears before bedtime.
For centuries, people bought bonds for income. Today, there is precious little income and folk are left praying for capital gain to make money from many bonds – that is only likely if QE continues, which itself relies on the global economy remaining in dire straits.
Myth #3: Bonds are way too expensive and should be avoided altogether
It’s difficult to argue that bonds aren’t expensive. In fact, they’ve never been quite as expensive as they are now. And in some ways, never have they been riskier.
Governments and companies have taken advantage of cheap borrowing conditions to issue loans lasting multiple decades. As a result, the average duration of the market (a metric that many investors benchmark themselves against) has steadily crept higher and riskier over the last decade.
Avoiding the direction of the market, therefore, may actually make a lot of sense since prices can hardly go much higher and it might only take a hint of inflation, economic recovery or more virus vaccine success to send prices plunging.
But there are lots of things a good bond fund manager can do to add value – or alpha – without chasing the direction – the beta – of the market. Remember, the global bond market is huge and not all bonds move in the same direction or by the same amount. We could buy US bonds and sell Canadian ones, or sell European corporate bonds and buy UK ones.
With around US$130 trillion worth of bonds in issue, the opportunity to seek alpha is sizeable and ever-present.
Myth #4: Government bonds don’t default so the return they offer is guaranteed
Everyone seems aware that corporate bonds carry credit risk and can default. But aren’t government bonds immune to that? Well, no.
The US government has a long tradition of failing to pay creditors (although, admittedly, things have been better in the past century) and the UK came close to defaulting in the 1980s. Need we mention the various country bailouts required during the eurozone debt crisis?
Another problem is that many government bonds now have ultra-low or even negative yields. So even if you think repayment is assured, you may only be guaranteeing a negative return. For instance, lend €100 to Germany for 10 years and you get €95 back! Lend £100 to the UK and you get £103 over the same period; however, if we adjust for inflation (let’s assume at 1%) then this means in real terms your £100 in gilts might only be worth £90. Not too good, is it?
Bonds have never been more expensive than they are today. Be very careful you know which part of the market you are buying; your bonds might not default, but they may guarantee a loss.
Myth #5: Bond prices all move in the same direction
All bonds fall in price when times are good and rise when times are bad. This means bond investors are doomed as the economy recovers from Covid-19, right? Again, no.
Over half the global bond market is made up of bonds issued by governments and, yes, these bonds often do well in times of strife such as the current pandemic given investors view them as low-risk safe havens. The rest of the bond market is company debt. Often these bonds can rise in the good times (or fall much less than government bonds) because their credit risk decreases as the economy and profits grow.
The decision on how to asset allocate within the bond market is of huge importance. A fund such as the Liontrust Strategic Bond Fund can move its assets from government bonds one day into corporate bonds the next (during April, for example, the fund increased its credit weighting by around 30% to take advantage of market distress).
Myth #6: High yield bonds are illiquid, junk instruments issued by small, unheard-of companies.
There are myths and misinformation aplenty about the world of high yield bonds, and this is perhaps the most common. However, one of the biggest issuers of high yield bonds is well-known global media giant Netflix, with a market cap approaching US$200 billion. Tens if not hundreds of millions of dollars of Netflix debt changes hands each day. Not small and not illiquid!
To illustrate the extent to which high yield bonds are used by mainstream companies, how about a quick ABC of issuers? Alcoa is one of the world’s leading manufacturers of aluminium which feeds into a range of products from cars to ‘tin’ foil; Bausch Health is a global ophthalmic specialist you’ve probably used if you wear glasses; and Citigroup is a global financial institution with US$100 billion market cap, whose subordinated debt is considered high yield.
Sure, there are many companies we have never heard of issuing bonds, especially in Europe. But we don’t need to buy them.
The market cap of the average issuer in the Liontrust High Yield Bond Fund is larger than the average market cap of companies in the FTSE 100.
Myth #7: All high yield bonds have the same high risk
Many think that all bonds in the high yield market are equally risky. But the high yield bracket is typically thought to covers bonds rated with a BB credit rating through to those with a C. The range of credit default risk here is massive: according to Standard & Poor’s, 0.6% of BB bonds default in any given year on average compared with a whopping 27% for bonds rated CCC/C.
In a world devoid of income, many people get sucked into the lower reaches of the high yield bond market and do end up exposed to an uncomfortable amount of default risk. But if you or your bond fund manager know what you are doing, it is possible to find good high yield income with moderate credit risk.
Myth #8: You don’t need to worry about currencies when buying bonds
A lot of investment funds make or lose as much money from currency as they do from their underlying assets. Bond managers often think they can handle currency risk. After all, isn’t it just a bit of macroeconomics, the same as bond investment?
Unfortunately, it’s not quite so simple. It’s easy to form an opinion on currency: Brexit is bad for sterling, as an example; but if we want to sell sterling, we need to buy something else. Say we sell sterling against euro on a Brexit view, but tomorrow Angela Merkel resigns – this would derail the trade regardless of whether the Brexit call was correct. There’s a huge range of factors that feed into currency moves.
The global bond market has done well this year. For euro investors, returns by 20 November had reached 4.0%. However, if the same investors had failed to hedge their currency exposure this return would have been just 1.8%. When buying bonds or a bond fund, be sure to understand what currency exposure you really have or you might get a nasty surprise.
Myth #9: Bonds all have maturity dates which offer an end date to your investment
In part, bonds’ maturity dates are what set them apart from a perpetual instrument like an equity. But many bonds – especially the riskiest – have embedded options allowing the borrower to choose the repayment date. Sometimes this can benefit bond investors, but in general, if a borrower is choosing to change repayment terms, it usually means it’s in their interests to do so (and not in the lender’s!).
Regulators have played their part in encouraging some of these instruments. Since the global financial crisis, banks have been able to issue hybrid bonds that convert to be considered part of its equity base if a crisis event threatens its solvency.
There are now specialist bond funds where all the assets are invested in such instruments. Of course, this brings concentration and correlation risks. But it also greatly increases uncertainty for investors, in extremis not only making repayment less likely but also making it difficult to assess when any repayment may take place. As always, it pays to make sure you understand the risk before investing in specialist structures. Make sure it does what it says on the tin.
Myth #10: Bonds can’t be ‘green’
Because bond investors lend to companies, whereas equity investors own them, it can seem they have little influence over the policies a company pursues. However, in recent years, the pressure to abide by all things E, S and G (environmental, social and governance) has filtered through to the bond market too.
Indeed, according to Moody’s Investor Services, from the start of 2020 to 31 October, a total of US$425 billion of sustainable bonds had been issued globally where the end use of the funds was earmarked for environmentally friendly projects. In addition, several ratings services not only produce a score for individual corporate or government debt but also calculate scores for specific investment portfolios and funds.
Increasingly, the opportunity and the liquidity of the green bond market is on a par with the traditional market, meaning investors can choose sustainability with both their head and their heart.
Myth #11: Bonds are lower risk than equities, so bond funds are lower risk than equity funds
Investors often think of bonds and bond funds as lower risk than many other asset classes. It’s arguably more important to understand the flexibilities of a bond fund than those expected to invest in higher risk asset classes.
Most open-ended investment funds have wide ranging powers. It’s always a good idea to understand how your money could be invested and what those powers allow the fund manager to do. You might have invested in bonds to reduce your investment volatility or perhaps to protect against risks elsewhere in your investment portfolio. If so, you might not want your bond manager investing in equity or taking currency positions. Many bond funds have the power to do so. Perhaps it is worth checking what you own?
Myth #12: Stockpicking and sector allocation should be left to equity investors
Name a sector of the economy and the chances are you can buy bonds in it. And that’s just what many passive funds or ETFs do. Sometimes this is great, sometimes not so much.
With investors increasingly focused on green issues, many companies with poor ESG scores are struggling to generate revenue. They are becoming riskier and more prone to default. Two of the biggest issuers of high yield bonds are energy companies and those focused on the technology, media and telecom sector. One sector has a huge carbon footprint and has suffered significantly as virus related lockdowns hit demand. The other sector? Well, demand for services has been boosted through the crisis and bond prices have rocketed.
You can buy bonds in almost any part of the economy but that doesn’t mean you should.
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