May 2014 - Strategic bonds
The resignation last week of Richard Hodges, manager of the Legal & General Dynamic Bond Trust, resulted in both queries about alternative funds and a renewed focus in the press on bond investments in general.
At FundCalibre, we are still quite wary of bonds. There are a number of factors at play, which may have a negative impact on the asset class, which has enjoyed a 30-year bull market, and returns achieved in the future are likely to be well below those investors have become used to.
Impact of QE
Firstly, there is quantitative easing, or QE as it is known. This is a name that has been given to the temporary policies adopted by central banks around the world to keep economies and markets above water, post the global financial crisis. They have bought up government bonds and hold more than their fair share, somewhat distorting the markets. As economies have started to look more healthy, central banks in the US and UK in particular have talked of slowing their policies before bringing them to a halt completely. What this action will result in is anyone's guess – it has never been done before so no-one really knows.
One of the main fears is that inflation will come into the system in a big way, and this can be very negative for bonds.
Then there are rising interest rates. In both the UK and the US, it's just a matter of when, not if, interest rates will rise. And, as the chart below shows, rising interest rates are generally bad for bonds and can lead to capital losses.
That said, the chart shows the impact of a 1% rise and we do not think that rates in either country will rise by that much or that they will rise very quickly. We think they will be very small and incremental changes. So the impact should be more muted. But it does mean that there could be a difficult period ahead for the asset class.
One of our biggest fears, however, is that liquidity – or the ability to buy and sell bonds – is much more limited today than it has been in the past. If a lot of people want to pull money out of bonds at the same time, and there are no buyers to match the sellers, dried up liquidity could become a major problem – much as it did in the property market in 2007/08.
It is for these reasons that we prefer Strategic Bond funds. We understand that some investors will still want to be invested in bonds for the income they provide or for the diversification they can offer a wider investment portfolio.
It is extremely difficult for individual, private investors, to know what type of bond they should hold at what time. Strategic Bond funds can invest in lots of different types of bond, moving between them as and when the fund manager thinks the environment is more or less favourable. Managers of these funds are also better able to manage interest rate risk and try to minimise losses that may otherwise occur.
L&G Dynamic Bond Trust was Elite Rated, but with Richard's resignation, the rating was suspended.
Other Elite Rated funds in this sector are:
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Clive Hale, Director - May 2014
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