15th May 2013
Interest rates may not rise for another couple of years says Richard Hodges, manager of L&G Investments’ Dynamic Bond Trust.
Hodges says: “Bond investors are concerned about interest rates rising but this is not something I’m expecting this year, and maybe not even in 2014 or 2015. The catalyst would be an uptick in economic growth and heightened inflation expectations, neither of which seems likely given the deflationary pressures that we are seeing in the market today. I expect economic growth to remain subdued, with austerity and deleveraging in the government and consumer sectors helping keep inflation in check. Central bankers should continue to keep bond yields low through quantitative easing too, but in my view this policy will have little economic impact beyond continuing to inflate the prices of financial assets.
“Today, the talk is more about deflation than inflation. We are seeing growth forecasts for major economies revised downwards and commodity prices on the decline – hardly a recipe for tighter monetary policy. At some stage, of course, global growth and inflation will start coming through, and when this happens I will reposition the fund to benefit from those trends. In the meantime, I have around 15% of the Dynamic Bond Trust invested in assets which mature in 2015 and are offering a decent yield. The maturity profile of these assets should allow me to reinvest the proceeds at what will by then be higher yields.
However Hodges says he has managed the fund to ensure relatively low sensitivity to interest rates.
“The duration (or the interest rate sensitivity) on the fund is reasonably low, particularly in comparison to a traditional government or corporate bond fund. In other words, if interest rates rise and government bond yields rise, longer duration funds are more likely to underperform the Dynamic Bond Trust. I repeat that I don’t expect interest rates to rise in the near future, but the risks of taking a long position in duration today are skewed to the downside. For me, there are more attractive ways to make money in the fixed income asset class.”
“Returns can be generated by allocating between the fixed income asset classes, taking advantage of relative value opportunities. I can also add value from changes in interest rates and make money regardless of whether yields are rising or falling.
The note continues: “Around a third of the Dynamic Bond Trust is invested in (predominantly UK-based) financials, in particular Lower Tier 2 banks and insurers. This is an area of the market I expect to be well-supported by demand from overseas investors facing negative interest rates in their domestic market. I particularly like non-callable bonds that mature within the next two to three years, where decent yield can be earned without taking on too much uncertainty over whether the bond is called (or repaid).
“Another key driver of returns has been the high yield market. High yield bonds have been well supported by investors looking for income and this has caused spreads to narrow. This has given us a lot of opportunities to add value, both from taking long positions to the asset class – 30% of the Dynamic Bond Trust is invested in high yield bonds – but also from adopting some more specific, tactical short positions as a way of containing volatility and adding additional revenue.
“Two thirds of the fund’s high yield holding is very specifically focused. A lot of it is in shorter duration bonds that yield roughly 4%, which might sound low compared to what was available in years past, but in the context of what’s available elsewhere, these yields are still attractive. High yield bonds have credit risk, of course, but the probability of default over the next 12-18 months in high yield remains very low in my opinion. That’s because issuers have been successfully coming to the debt markets to raise capital and funding costs remain low.”