Bonds or cash in asset allocation? A question from an IFA.

Sent by anonymous, 23 May 2007:

"As an IFA I am constantly reminded to adopt the principles of asset allocation and ensure that most clients have a spread of equities and bonds within client portfolios. However the outlook for bonds from most quarters is poor and many investors are suggesting that their bond allocation would be better off in cash where the capital value is secure and the yield much higher than gilt or bond funds.

What is your view and what advice could you give to IFAs struggling with this dilemma?"

First of all, thanks for the question. We want this blog to be interactive, and we’re happy to receive any questions, comments or market thoughts readers might have.

Whilst we are, of course, forbidden to offer investment advice, we can share your pain. With the UK yield curve inverted (yields on longer dated bonds yielding below the Bank of England rate) you have to believe that the price of these longer dated assets will rally simply to match the return on cash. And once you’ve paid management fees the hurdle is even greater. With some of the internet banks offering rates of 6% (virtually risk free as the deposits are largely protect by the government) it’s understandable that clients have found traditional corporate bond funds unattractive, especially if held outside a tax free ISA. As such we have seen that the most popular area for investors in our funds in recent months has been into money markets and other "cash plus" type products (including leveraged loans). These instruments pay a floating rate of return linked to base rates, plus a margin to reflect credit risk. So for example a Floating Rate Note (FRN) issued by AA rated Citibank might pay 3 month Libor (currently 5.78%) plus 9 bps, so 5.87% in total. A similar instrument issued by a sub-investment grade company like Saga Holidays might pay 8.28%, and in both cases if interest rates rise – as we expect them to – the returns will also increase. So if you agree with us, and expect higher interest rates, look for bond funds with high exposures to FRNs within their portfolios.

An alternative strategy would be to look at funds which can use the new UCITS3 wider powers; these funds may be able to take bearish views both on interest rates and on credit spreads, and thus can make positive returns even if bond markets are selling off. Richard Woolnough’s M&G Optimal Income fund, which has the ability to express such bearish views, has seen positive returns since launch in December last year, outperforming the average high yield fund, money market fund, corporate bond fund and gilt fund (the latter two asset classes having had negative returns over the period).

A final thought would be to think about the purpose of a diversified asset allocation, and the point of bonds. None of us has perfect knowledge, and whilst the global economy feels lovely right now, we do worry that a US recession could be a possibility in 2008. In that circumstance – or indeed in a world where terrorism, bird flu, and oil shocks are possibilities – bonds may perform very strongly. I’ve been involved in the bond markets since 1992, and I think that it’s true to say that fixed interest NEVER looks fantastically attractive! The yields available will always look meagre compared with "expected returns" on equities and other riskier assets – yet there have been many periods over those past 15 years when bonds have outperformed equities, sometimes significantly. Asset allocation models are there to help match the clients’ assets to their expected liabilities. These liabilities almost certainly involve the provision of a fixed income on retirement, or an annuity purchase, and in these circumstances to buy anything other than bonds is taking a bet – a bet which many FTSE companies took when they bought shares for their pension funds rather than bonds, and one that went very wrong in 2001-2003 and resulted in the pension fund deficits that persist to this day in many cases.

This is not me being fantastically bullish on fixed interest – you can see from our fund positioning that we are short duration compared to our peers, and also underweight in credit risk. But as long as central banks keep inflation under control (and that will involve at least one more UK rate hike), the interest rate environment could be very different next year, and bonds could start to rally in anticipation of weaker growth. Ten year gilt yields have nearly reached 5.25% (having been at 4% at the start of 2006) – a level that’s starting to look like good, if not compelling, value. But we think it will take a normalisation of the yield curve (with higher long dated bond yields than cash rates) before either we, or our clients, back up the trucks and go heavily overweight in the bond asset class. Sent by anonymous, 23 May 2007:

"As an IFA I am constantly reminded to adopt the principles of asset allocation and ensure that most clients have a spread of equities and bonds within client portfolios. However the outlook for bonds from most quarters is poor and many investors are suggesting that their bond allocation would be better off in cash where the capital value is secure and the yield much higher than gilt or bond funds.

What is your view and what advice could you give to IFAs struggling with this dilemma?"

First of all, thanks for the question. We want this blog to be interactive, and we’re happy to receive any questions, comments or market thoughts readers might have.

Whilst we are, of course, forbidden to offer investment advice, we can share your pain. With the UK yield curve inverted (yields on longer dated bonds yielding below the Bank of England rate) you have to believe that the price of these longer dated assets will rally simply to match the return on cash. And once you’ve paid management fees the hurdle is even greater. With some of the internet banks offering rates of 6% (virtually risk free as the deposits are largely protect by the government) it’s understandable that clients have found traditional corporate bond funds unattractive, especially if held outside a tax free ISA. As such we have seen that the most popular area for investors in our funds in recent months has been into money markets and other "cash plus" type products (including leveraged loans). These instruments pay a floating rate of return linked to base rates, plus a margin to reflect credit risk. So for example a Floating Rate Note (FRN) issued by AA rated Citibank might pay 3 month Libor (currently 5.78%) plus 9 bps, so 5.87% in total. A similar instrument issued by a sub-investment grade company like Saga Holidays might pay 8.28%, and in both cases if interest rates rise – as we expect them to – the returns will also increase. So if you agree with us, and expect higher interest rates, look for bond funds with high exposures to FRNs within their portfolios.

An alternative strategy would be to look at funds which can use the new UCITS3 wider powers; these funds may be able to take bearish views both on interest rates and on credit spreads, and thus can make positive returns even if bond markets are selling off. Richard Woolnough’s M&G Optimal Income fund, which has the ability to express such bearish views, has seen positive returns since launch in December last year, outperforming the average high yield fund, money market fund, corporate bond fund and gilt fund (the latter two asset classes having had negative returns over the period).

A final thought would be to think about the purpose of a diversified asset allocation, and the point of bonds. None of us has perfect knowledge, and whilst the global economy feels lovely right now, we do worry that a US recession could be a possibility in 2008. In that circumstance – or indeed in a world where terrorism, bird flu, and oil shocks are possibilities – bonds may perform very strongly. I’ve been involved in the bond markets since 1992, and I think that it’s true to say that fixed interest NEVER looks fantastically attractive! The yields available will always look meagre compared with "expected returns" on equities and other riskier assets – yet there have been many periods over those past 15 years when bonds have outperformed equities, sometimes significantly. Asset allocation models are there to help match the clients’ assets to their expected liabilities. These liabilities almost certainly involve the provision of a fixed income on retirement, or an annuity purchase, and in these circumstances to buy anything other than bonds is taking a bet – a bet which many FTSE companies took when they bought shares for their pension funds rather than bonds, and one that went very wrong in 2001-2003 and resulted in the pension fund deficits that persist to this day in many cases.

This is not me being fantastically bullish on fixed interest – you can see from our fund positioning that we are short duration compared to our peers, and also underweight in credit risk. But as long as central banks keep inflation under control (and that will involve at least one more UK rate hike), the interest rate environment could be very different next year, and bonds could start to rally in anticipation of weaker growth. Ten year gilt yields have nearly reached 5.25% (having been at 4% at the start of 2006) – a level that’s starting to look like good, if not compelling, value. But we think it will take a normalisation of the yield curve (with higher long dated bond yields than cash rates) before either we, or our clients, back up the trucks and go heavily overweight in the bond asset class.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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