Bonds, Interest Rates and Inflation
Tideway Market Update, 19th February 2021

James Baxter, Managing Partner

Of the c.£400m of Tideway Assets Under Management more than half is allocated to fixed income funds, often referred to as bond funds. In response to a client request, and having focused on equity markets in recent updates, I wanted to look at our recent bond fund returns, what is going on at the moment and the outlook for bonds in 2021.

Now is a timely point to take a look and remind ourselves that there are bond funds and there are bond funds!

What has been happening?

The chart below shows the return on our top bond holdings versus the IA sector averages for Sterling Strategic bonds, corporate bonds, global bonds and UK gilts for the last six months.

6 Months Performance to 18th Feb 2021

From the top performing fund to the bottom, there is a 13% difference in returns in 6 months. UK Gilts, at the bottom, are finally doing what we have expected, as gilts have fallen from highly inflated prices post the COVID scare and as the world begins to contemplate some sort of normality as the year goes on.

The yield on 20-year gilts, which feeds into annuity prices and DB pension transfer values, has risen from around 0.5% to 1.15%. You may remember that they were over 4% as recently as 2010. We can expect DB transfer values and annuity prices to start to fall if this continues.

Broadly invested corporate bond funds and passive bond funds have been dragged down by this fall in gilt prices. This has been exaggerated further in global bond funds as sterling has begun to recover some strength after Brexit and the recent success of the vaccine roll out program. As with rising risk-free yields, do not get too excited. Sterling reached a three year high today against the US dollar at $1.40 but it was $2 in 2007 before the financial crisis.

The Artemis managers continue to show their strength making more than 2% than the average fund in 6 months. Our high yield bond funds have continued to recover from last March’s falls and the two short-dated funds, which are less exposed to interest rate moves, have delivered really stable returns. Whilst we take more risks around individual bond defaults in these higher yield funds, they are well diversified and, as can be seen above, the risks to interest rate rises are considerably lower. In all, the combination of our selected funds has given us a very positive contribution to portfolio returns over the last six months.

The outlook 

Looking back is obviously the easy bit and what happens next is always harder, which is why we do not try and put too much emphasis on timing and do try and have a diversified range of strategies in each portfolio.

In broad terms there is a school of thought that says there will be a big uptick in demand and the economy as we emerge from lockdown and splurge on pent up demand. This will lead to inflation and force those risk-free gilt yields up further – gilt prices continue to decline.  Those who look to China can see a strong recovery driving up commodity prices.  Will this happen more broadly across the world as we all get vaccinated?

However, if the splurge is more muted and we remain caught up with social distancing and quarantine rules, then the recent rate move could be enough for now, or even be slightly over done. There is certainly considerable ‘scarring’ from the lockdown with many businesses suffering irreparable damage and continuing underlying deflationary pressures from global competition, technological advancements, and climate change agendas. 

We do not have a strong enough conviction either way to make big bets on either outcome.  Investing in gilts and very low risk bonds paying sub 2% still leaves us with the returns below inflation after fees, so we will continue to give them a miss.  Although, if gilt yields rise much more and inflation stays low, then we may be able to invest in risk free returns to get inflation plus returns.  Looking back in history this has often been the norm and we will keep an eye out for a return of such an opportunity.

If gilt yields go up further again, we may see capital declines even in our higher yielding funds, but these should be recovered reasonably quickly through the higher interest rates these funds are earning.

It is worth noting that if you are in a fund tracking 20-year gilts or very low risk bonds and these fall by 5% in capital value as they have in the last two months, with a 1% yield it is going to take at least 5 years to get your money back after costs. Our two high yield managers continue to enjoy gross yields of almost 5% so would recover the same drop in capital values in just over a year.

We have faith in our active managers to navigate these moves in either direction, something which for the last six months has delivered a big premium return over a broad-based passive bond strategy.

Investment Committee Update

Nick Gait, Investment Director

Tideway’s scheduled quarterly Investment Committee was held in early February with the agenda covering current macro-economic themes; potential for inflation & rising yields, the value-growth rotation, Emerging Markets versus Developed Markets as well as market wide valuations and a review of performance, both at a portfolio level and at the individual manager level. The committee concluded that it was satisfied with the positioning of portfolios and its current exposures with only two minor changes to report to you.

The first change that we have made was to increase our exposure to the Montanaro Better World Fund whilst reducing exposure to Lindsell Train Global Equity to fund the purchase. We originally opened our position in the Montanaro Better World Fund in early November last year.  As a small / mid cap offering, with the potential for higher volatility, the committee decided to proceed with caution and implement in stages. The fund has performed well since it was added and has allowed us to gain additional comfort in the meantime. As an Impact strategy with a rigorous integration of Environment, Social and Governance factors (ESG), we believe there will be significant structural tailwinds driving performance in the future.

The second change was an alteration to our Equity Income portfolio with an increase in allocation to our current holding in the Jupiter Asian Income fund run by Jason Pidcock to reflect our current preference of being overweight the Asia region. We have been invested in this strategy since 2017 (it launched in March 2016) and continue to have strong conviction in the manager.

As a reminder, the strategy seeks to deliver a yield 20% greater than that of its benchmark by investing in large capitalisation companies in the Asia Pacific region. In constructing the portfolio Jason Pidcock employs a bottom-up fundamental approach combined with macro-economic considerations. He closely monitors all companies within the fund, but experience has taught him that to achieve investment success in Asia, macro-economic factors must also be considered in the investment process. Key factors that the manager analyses at the company level include corporate governance, competitive advantage, balance sheet strength, cash flow and liquidity of the company’s stock. On the macro side, factors such as geopolitical risk, trade protectionism and corruption are considered.

Overall, we remain underweight (no exposure) government securities preferring the incremental income provided by Credit (corporate debt - Investment Grade, High Yield and Hybrid Securities); overweight the Asia Pacific region and Emerging Markets, overweight UK as well as being underweight the US with highly valued tech companies our primary concern. We remain excited about our domestic UK position, currently represented by Unicorn UK Income with at present a double discount on offer with the UK trading at a discount to its global peers and UK small caps trading at a discount to UK large capitalisation companies. In addition, we believe in our managers ability to delivering alpha (outperform their benchmarks) in what is an increasingly volatile marketplace, a more beneficial environment for active stock pickers. We maintain a broad range of style exposures and are constantly reminding ourselves of the benefit of a well-diversified portfolio.

In the coming weeks we will provide an update from one of our fixed income managers, which has been requested by a handful of clients. As ever please feel free to provide feedback and let us know if there are any topics where you would like us to focus.

Have a good weekend,
The Tideway Team

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The content of this document is for information purposes only and should not be construed as financial advice

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