Share Prices & Company Research

Press Release

10 October 2016

Fixed interest in your portfolio ~ the Volvo in your fleet?

Asset allocation decisions don’t come trickier in the current environment than those surrounding fixed interest. Following the raft of quantitative easing across multiple geographies, exceptionally low interest rates and indeed the negative interest rate policies adopted in Europe and Japan, we find ourselves confronted with some stunning statistics, not least of which is that UK government bonds, or gilts to give them their short name, have returned 13.3 per cent year to date (to 10th October).

13.3 per cent in 10 months! For gilts! Your safe haven asset! Your low volatility, low risk, low return, slow and steady foundation block has just returned nearly double the long-run expectation for the highest risk asset class of equities (c.7 per cent). So when the Volvo in your portfolio performs like a Ferrari the inclination is to sell it and wait until it comes to its senses.

However, there are two problems with taking this decision. One, you would have had a similar inclination in 2011 when UK gilts returned 16.8 per cent, or maybe in 2014 when they returned 14.1 per cent that year. Suffice to say, you might be nursing some underperformance against any benchmark that has a UK gilt exposure if you had made either of those decisions. The other problem comes down to having a properly diversified portfolio. A truly diversified portfolio that can offer some protection in times of difficult market conditions needs low volatility, low risk, safe and secure assets to offset the riskier parts of the portfolio, such as equities. The story is very similar in the corporate bond market, and we reached the incredible milestone in September of public companies Sanofi and Henkel selling bonds to investors for more than the investor will get back, negatively yielding from the outset.

So, what is the solution? Well, buying into bond funds currently feels very difficult given recent performances and the future return expectations. With a bond fund you do not have the comfort of par value giving you a defined return expectation at the outset, and, therefore, you will be at the mercy of mark-to-market movements and potential capital losses. Therefore, the answer must surely be to very carefully select specific bonds that you can then derive a defined return outcome from, and, barring default risk of course, protect you from capital loss. The yield to maturity might not be what it once was, but you still have a defined return at the outset (you know the income you’ll receive and the capital that you’ll get at maturity) and it does allow you to still have that fixed income tool in your belt. If recent equity market exuberance is anything to go by, that tool may well be needed once the Brexit negotiations start in earnest and things start to look a little messy again.

It is worth remembering that the day after the Brexit vote the FTSE 100 opened down by about 9 per cent, whilst gilt prices rose showing an intraday outperformance of at least 10 per cent by various gilts. I might not want a fleet of Volvos, but one or two particularly good ones serve a purpose.
Fixed interest in your portfolio ~ the Volvo in your fleet?
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