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As rates rise, investors risk overstretching for yield

Fixed income investors weigh up the challenge of trying to generate positive returns as duration lengthens


Sebastian Cheek

It’s been the big question on portfolio managers’ lips for a long time now: how do you generate a positive return in fixed income?

The classic way to play the asset class has been to benefit from the diversification afforded by government bonds when interest rates fall, and stock markets sell off.

But with central banks indicating that interest rates are now on an upward path, and inflation set on the same course, it is vital those hoping for a yield from fixed income carefully manage their exposure to mitigate the risk of suffering sharp falls in capital.

Beware duration risk

According to AJ Bell head of active portfolios Ryan Hughes, the dangers of capital erosion are particularly acute given the UK gilt index now has a duration of 12 years, up from six years before the financial crisis. This he says has clearly increased the interest rate risk for a fixed income investor significantly over the last decade.

To protect against capital losses, Hughes aims to manage the duration position in AJ Bell’s portfolios by focusing on short-dated gilt exposure. He also diversifies exposure across UK corporate bonds, UK high yield and emerging market debt (EMD) to avoid being overly concentrated in one area.

He says: “EMD is an interesting area, with capital values having fallen around 7% over the year, but a yield of around 7% is now available.”

Psigma Investment Management head of investment strategy Rory McPherson says fixed income is “a tricky one” because there are no clear winners out there as everything is fairly fully valued, although there are some good assets to buy.

Like Hughes, McPherson says Psigma doesn’t want to play interest rate risk, preferring to own specific credits including asset-backed securities, such as airport leasing, mortgage-backed securities and certain high-yield bonds.

“What we end up with is fixed income that provides a yield of between 2% and 6%, depending on what sort of instruments we are looking at, is not sensitive to movements in interest rates and, importantly, is fairly different to what is going on in the equity market.”

McPherson concedes this does expose portfolios to some equity-type risk, but the team justifies this by holding less in equities.

He also admits that owning US mortgages is controversial given they were deemed to be the root cause of the financial crisis in 2008, but he says they are actually really safe investments.

“The key thing is the mortgages we buy are well-seasoned, they have terms of more than 10 years, so the underlying investors are solid and have got through the credit crunch.”

Other sources of yield

Hughes says in AJ Bell’s income portfolios he uses Reits and infrastructure to generate a higher income but is aware that over short periods these asset classes still have high equity correlation.

He says the iShares MSCI Target UK Real Estate ETF offers a yield of about 2.5% and gives exposure to liquid Reits but dampens the equity volatility by holding index-linked gilts alongside them, while the L&G Global Real Estate Dividend Index yields more than 3% at a cost of only 0.2% per annum.

In infrastructure, Hughes uses the Premier Global Infrastructure Income fund which currently yields more than 5% due to its exposure to emerging markets.

For other sources of yield, Psigma has a portfolio of infrastructure equities in the regulated industries and utilities space which also typically yields about 5%.

In addition, Psigma looks to UK equity income which currently yields about 4%. It uses the Artemis Income fund and Royal London UK Equity Income which McPherson describes as having “solid, steady Eddie type managers” who tip big blue-chip companies that can grow their dividends.

Try not to overstretch 

But Hughes is cautious about overstretching for yield.

“It is important to realise that the days of generating a solid yield in a relatively low risk manner have gone,” he adds. “With bond yields still at low levels and offering capital risk, to generate a sustainable attractive yield of over 3.5% per annum means that investors have to take far more risk than they have done for many years. This comes with a consequence that is likely to mean there will be more volatility for income investors.”

This risk is also on McPherson’s radar but he says this is mitigated because Psigma accesses its strategies through bespoke mandates only available to its clients.

“This is important to us because we want to have full visibility of the underlying investments,” he says. “We don’t want to get trapped in liquidity issues which you can get with bigger funds. You might get a bunch of investors who take their money and decide to sell the easy liquid credits and leave you with the illiquid stuff which is not what you want.”

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