Bond funds have seen bumper inflows in recent months as rising prices have boosted investor returns — but asset managers are starting to ponder when their fortunes might change.
Companies with large fixed income offerings such as M&G Investments, Invesco Perpetual and Legal & General are among those bracing for a fall in prices after banking analysts began to warn of the risks of a “bond shock” — a sudden and unexpected rise in yields.
All three fund houses have begun to swap their holdings of longer-dated debt for shorter-dated debt, which is less sensitive to interest rate rises and will reduce the funds’ capital losses in the event of a collapse in prices.
Ben Bennett, head of credit strategy in asset manager L&G’s fixed income arm, said the company had just taken the decision to reduce the duration of the bonds in its portfolios, while M&G said it has been scaling back “aggressively” this year.
Invesco Perpetual, meanwhile, says it sharply decreased the average duration of bonds in its portfolios after sterling plunged in value following the Brexit vote.
Eric Lonergan, multi-asset fund manager at M&G Investments, said bond markets were currently “a lot riskier than investors have come to believe”.
“It looks like people have become very complacent about the risks in bond markets,” he said. “[If interest rates rise] these bond markets will sustain big losses.”
Adrian Hull, fund manager at Kames Capital, said he was unconcerned at the moment but agreed that “doomsters” such as Bank of America Merrill Lynch and Goldman had a point. “The market has been complacent about the idea that rates might go up. They think rates may never go up,” he said.
For retail investors with money in bond funds, a sharp drop in the price of UK bonds will compress the fund’s total return. This would be good news for those seeking income, however, as rising yields would mean investors seeking income could potentially return their money to fixed income instruments rather than relying on “bond proxy” stocks.
Rob Burdett, head of multimanager F&C, said he was “taking profits” by pulling his money out of corporate bond funds. “We’re coming closer to the end of the default cycle,” he said.
Although fund managers are beginning to make preparations for a price decline within their portfolios, however, they remain confident that a sudden collapse scenario can be kept at bay.
Mr Bennett said he was not too worried. “If rates do go up and there’s a bond tantrum, there are a lot of people who will start buying again, like pension funds.
“This is not the same as the dotcom bubble in 2000 when everyone and all the taxi drivers were buying tech stocks,” he added.
Stuart Edwards, fund manager at Invesco Perpetual, agreed: “It’s unlikely that we’ll get a material sell-off. Nobody likes their bond valuations, they’ve been quite expensive for some time now, but what are the alternatives?”
A dip in performance could cause large outflows, in turn triggering liquidity issues as fund managers rush to sell bonds.
Mr Bennett said he did not see that happening. “There is such support from central banks that they won’t allow that type of collapse in liquidity,” he said.
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