With
capital preservation a prime concern of charities, recent
rising interest rates and the consequent eroding of the capital
value of their fixed income portfolio is not good news. But
if the current economic climate turns, as many commentators
believe could happen over the next few months, a less buoyant
economy would favour bonds.
Over the last few years the signs have been that charities
are reducing their allocation to fixed income. According to
figures from the WM Performance Services, at the end of 2006
weighted average allocations to bonds in WM’s full UK
charity universe stood at 11.2 per cent compared with 14.7
per cent at the end of 2001.
This may reflect charities’ lesser focus on fixed income
compared to equities. Nevertheless bonds perform a useful
role in a charity’s portfolio, both in generating an
income stream to enable them to make disbursements and for
risk reduction.
“I think it’s probably fair to say most charities
haven’t paid as much attention to the bond portfolio
as the equity portfolio,” says Alasdair Gill, leader
of the charity team at Mercer Investment Consulting. “It’s
such a small proportion it’s seen as a bit of a poor
relation to the equity portfolio.”
In the current rising interest rate climate in the UK, the
view from BlackRock is that holding cash is preferable to
bonds at the moment. “Our view for the UK bond market
for over a year now is that cash is king,” says Jo Howley,
director of fixed income. “We have cash waiting for
a bond market sell-off to reinvest at lower prices. We have
seen part of that sell-off but we would still expect the market
to go a bit further.”
The advice from Denis Gould, head of fixed income UK at Axa
Investment Managers, is for charities to hold firm on their
bond portfolios. “Charities are holding bonds now and
holding them to produce income; my recommendation would be
‘don’t panic’,” he says. “Bond
prices are coming under downward pressure, [charities] will
be losing a little but they are still getting coupon income.
My advice right now would be to look through increasing interest
rates – we are possibly going to have a couple more
from Europe, maybe in the UK, the US is a bit more questionable.
Accept that these yields aren’t bad value any more.”
Recent history of rising interest rates has not favoured bonds.
Bonds tend to under-perform in periods of strong economic
growth and rising inflation. But after a series of interest
rate rises, and consequent depressed bond prices, now would
not be the optimal time to be selling out of the asset class.
With interest rates likely to be near their peak, sticking
with them seems the better option.
UK inflation is likely to moderate quite rapidly now, says
Philip Barleggs, head of fixed income product management at
Insight Investments. “Our view is the Bank of England
has either finished raising rates or there is one more to
come,” he says. “It would not make sense to be
shifting away from bonds in a period when they have probably
performed their worst.”
Looking further ahead he thinks the economic climate should
be cooling to favour UK bonds. “A year ahead if we see
a slowdown in inflation and probably in the economy, if a
moderation in the housing market comes through, that is good
news for bonds; it should mean bond yields will gradually
decline. The Bank of England will start reducing rates.”
UK bonds are currently demonstrating an inverted yield curve,
with yields at the short end of the curve higher than those
at the long end. The more orthodox curve produces higher yields
for longer dated bonds to compensate investors for the greater
risks associated with them.
This anomaly has been driven by the high demand for long dated
bonds from pension funds, which have been big investors in
bonds with maturities of 20 or 30 years in order to match
their long-term pension liabilities.
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Adding value
So given that UK bonds are in the doldrums, what can charities
ask their investment managers to do to add value? Most charities
would be asking their bond manager to look tactically across
the yield curve for pockets of value, says Mercer’s
Gill: “In the short term the manager will be looking
across the yield curve to pick out the best yielding bond
instruments. One year bond yields are close to six per cent
now which is probably the peak of the yield curve.”
Diversification into corporate bonds, at least at investment
grade, will not contribute significantly to performance
since there is little difference between investment grade
bond yields and gilt yields. Moving further down the ratings
enables investors to pick up yield, but the increased risk
might be a barrier for risk averse investors like charities.
AXA’s Gould has some reservations about high yield:
“It does seem like the spreads are very low on high
yield because there is so much money chasing a bit of extra
yield,” he says. “Also there’s the composition
of that market: there are a lot of CCCs in there, you might
do ok, but for me the amount of risk you are putting for
the amount of extra return especially for a charity, I’d
say, is a step too far.”
But Roger Webb, head of credit at Morley Fund Management,
thinks high yield is worthy of consideration. “I always
wonder why people don’t look at high yield,”
he says. “They look at equities quite happily and
it’s less risky than equities.” But he suggests
that high yield bonds look better as an alternative to equities
than bonds. “Obviously government bonds into high
yield is a big step in terms of risk profile; equities into
high yield bonds is a step down in terms of risk profile,”
he says.
BlackRock’s Howley favours diversification into European
or global markets. “On our active funds we have sold
UK bonds into European bonds on a currency hedged basis,”
she says. “We think they offer better value than UK
bonds. For investors such as charities looking for good
positive total return without massive amounts of volatility
the key thing to consider is diversification.”
She advocates the global bond market for three main reasons:
these are diversification; relative cost compared to expensive
UK bonds; and, because UK cash rates are relatively high,
looking at a global comparison on a currency hedged basis
can provide additional yield.
Though the European yield curve has the more normal shape
of higher yields at the long end, Barleggs at Insight expects
over time it will also flatten to resemble the UK’s.
“The interesting thing from our perspective is, right
at the very long end, European yields are actually above
UK yields; this is a bit of an anomaly. In our view that
anomaly will gradually be eroded simply because, as in the
UK, an increase in institutional demand is likely to happen
in Europe. Some Dutch pension funds have more or less the
obligation to go out and purchase longer dated assets; this
will help drive down yields at the long end in Europe and
push up prices. We expect in the UK there will be a significant
amount of supply at the long end both from government and
from companies, so you will get a push both ways in favour
of Europe.”
Nevertheless he feels that prices for shorter dated bonds
in Europe are likely to suffer from further rates rises
from the ECB to keep inflation under control in a rapidly
growing economy.
Gould says there are opportunities for bond managers if
charities are prepared to allow their bond managers some
freedom. One way is to exploit the differences in value
between similar credits in different markets, say where
a corporate bond may have a different yield in the UK and
Europe, perhaps because investors in Europe have neglected
a particular credit or one part of the yield curve. Another
opportunity is offered by the Japanese market, where investors
can profit from the steep yen yield curve.
“What you can do at the moment is buy Japanese 30-year
yen bonds, hedge the currency back to sterling and you have
effectively got a government bond which yields currently
two and a half per cent more than long gilts because the
UK yield curve is inverted,” he says.
“There are opportunities out there if charities allow
their managers to play with them.”
Currency hedging is in itself an opportunity to add further
yield as well as dealing with currency risk, according to
Barleggs at Insight. “If you do hedge the currency
you get a further yield enhancement because interest rates
in Europe are much below interest rates in the UK,”
he says. “So to our mind it’s one of those win-win
situations which is one you still have to keep your eyes
open on.”
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