Bizarre Bond Choices - what's going on?

Fri 13 Apr 2018

By Brian Dennehy

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Market commentary


“Investors appear to be shunning UK Equity Income funds and buying Strategic Bond funds. Why so if interest rates are heading up?” so we were asked this week. “What about if you have an income priority? Would you recommend any bond funds?”


To answer the last question quickly, I would not recommend any bond funds for income.  Below is a lot more flesh on that answer, starting with the pivotal liquidity problem.

Bond funds are not just an accident waiting to happen, but a catastrophe waiting to happen.

Touching on the stock market first, for context, the role of computers is no longer fringe – to a large extent, computers and robots are the market.  It is reckoned that only 15% of trading volume is driven by humans.  Moreover, much of this trading is very short term, relies on small incremental gains, and have absolutely no tolerance of sharp falls.  This means any rush for the exit will make Black Monday ‘87 look like a tea party. 

Robots don’t bluff. Robots don’t hesitate, have long lunches, or get distracted by calls from home. Robots sell rapidly. They don’t panic or worry about whether they will have a job tomorrow. They stick to pre-programmed stop-loss limits. In a downturn it will be machine against machine.

When liquidity was all in one positive direction the central banks had markets in the palm of their hand, but now QE is morphing to QT (quantitative tightening).  It will be bad for stock markets, but worse for bonds:

  • Quantitative tightening (QT) will result in massive new supply of bonds
  • i.e. bonds were being hoovered up by central banks, now they won’t be.
  • If you increase supply of something prices go down…
  • …in other words bond prices will fall.

Then there is the quality of bonds:

  • The quality in new high yield bond issuance is horrible.
  • Covenant-lite bond issuance is rising…
  • …from 10% of the total 4 years ago to 30% today.
  • Cov-lite means the bond issuer has more ways to wriggle out of its commitment.

As one broker in New York put it:

“Bond terms never got this bad in 2007. The contracts… are the worst they’ve ever been.”

You don’t get correction in these sorts of bonds – you just get wiped out

In 2008 many investment grade bond funds came close to suspending dealing. Now liquidity is inherently worse, and all the more so with lower quality high yield bonds.  When a volume of investors want to sell, there is no one to buy. In 2008 many investment-grade (let alone high yield) bonds could not find a buyer at any price – or at least not easily. Bond fund managers were shaken very badly – it was never meant to be like this – after all, aren’t these lower risk investments?

A good number of investment grade funds came close to suspending dealing in 2008/9.  Now liquidity is inherently worse (e.g. investment banks in scale don’t provide liquidity and prices any more).  It is worse still with higher yield bonds, so on sharp falls investors (including robots!) will sell what they can, which will be higher quality bonds and equities.

A nasty spiral, and rapid contagion.

Be wary of strategic bond funds, where many investors rush when more focussed bond funds are struggling. Where do strategic bond funds get most performance from? High yield bonds. Plus up to 20% in the stock market.

Allowing for all of the above, it is a puzzle that Strategic Bonds are the top-selling sector.  What is going on?

These sales are not a mass of decisions made by individual investors.  Rather these are largely made on their behalf within discretionary portfolios and fund of funds, so called expert investors and asset allocators.  Such quasi-institutional investors have an unfortunate tendency to herd – the best example of which was after the Brexit vote, when they tried selling en masse – in contrast the investing public sat tight.

I have observed over the years that when markets are expensive or opportunities are unclear investors tend to herd into “bitsa” funds – bits of this and bits of that.  So Strategic Bond funds and Mixed funds tend to come to the fore.  We have observed both in recent months.

The idea that fund managers of these bitsa funds have a magic formula or special insight to avoid a hole which is deepening and darkening is mis-placed.  The evidence of this was a key motivation for my book, “Clueless”.

Turning specifically to income generation, I am not sure how many investors are buying bond funds for income.  My guesstimate is that it will be 20-30%.

With a long retirement ahead investors must anticipate inflation risks, and not be seduced by current low inflation.  Investors need not just a reliable source of income, but also one where the income will grow over time – bonds and bond funds simply can’t do this – they are called “fixed” interest investments with good reason.

In contrast, there are a raft of equity income funds (unit trusts and investment trusts) with honorable track records of maintaining and growing income payouts over long periods.

But what about the risk to capital?  First and foremost investors need to stop obsessing about volatility in the capital value.  They need to re-focus on their priority, a growing income, and this does necessitate a change in mindset. Think of an income portfolio like your heart pumping out blood - the heart continually changes shape as it pumps out a steady stream of blood.  The capital value of your income portfolio will also vary from day to day, but there will be a steady flow of income.

Of course, equity income funds have downside risks too – when the US stock market enters its next bear market it is a long way down before their market becomes cheap, 50% losses at least.  Where the US goes the UK will follow.  Since 1987 complacency has grown around the assumption that even if falls are sharp, they will not be prolonged – central banks, particularly the Federal Reserve, will have your back and do what is necessary to engender a market recovery.  But in a recent speech, the new chairman of the Fed (Jay Powell) made it clear he has no intention of bailing out tumbling equity or bond markets, says Ambrose Evans-Pritchard in the Telegraph.

This raises the risk that markets could stay down for many years – what we call The Japan Problem.  While this might remain a small risk, if it did occur the consequences will be devastating for many, so the risk cannot be ignored.

The other problem is that should this unfold, no one knows when.  Perpetually there is someone, often appearing authoritative, who will tell you the market is going to Crash tomorrow.  How do you strike a balance?

If you use equity income funds for income generation you need a contingency plan.  This will be a mix of a higher than normal cash levels as volatility builds alongside extreme valuations, but also a stop-loss strategy.  To do a workable stop-loss strategy proper credit requires a lot more to be said – so I will leave that for another day!




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