Bond investors can still thrive even outside the comfort zone

Two weeks ago I was fortunate enough to hear a number of fund managers talk on various aspects of both global and American stock markets. At the event, hosted by Schroders in New York, I was particularly struck by three presentations on bonds. One was from the guest speaker Jim Caron, managing director at Morgan Stanley, whose worry was liquidity – the ease with which bonds can be bought or sold. During the bull market of the past 30 years, the size of a fund hardly mattered, in his view. All a manager had to do was sit back and let the assets accumulate. However, in more difficult times, size does matter. In the present day, at the bottom of an interest rate cycle, it is much harder to generate returns.

For example, rates in New Zealand are falling, but there are only 11 traded bonds in that area. Portugal provided another opportunity, yet managers running huge funds were not able to build enough of a position to benefit. In other words, the very size of the fund will dictate the strategy – hardly an ideal position.

So what else does the bond world have to offer?

Wesley Sparks at Schroders, suggests American high-yield corporate bonds could be an area of promise. With interest rates odds-on to rise in the US when the Federal Reserve meets in December, this could seem perverse – surely this would be the worst time to buy US bonds?

However, high-yield bonds are much more sensitive to economic growth than rate movements. This is simply because the companies issuing the debt are often relying on their ability to grow, in order to payback their debt.

Provided interest rates don’t rise dramatically, the US economy should continue to strengthen, which provides an attractive environment for high-yield bonds. In Mr Sparks’s view, this is quite likely – he doesn’t anticipate more than three rate rises in 2016, with the cost of borrowing settling at 1 per cent.

Jim Barrineau of Schroders, suggests an opportunity has arisen in emerging market debt. Both equities and bonds in these areas have had a torrid time in recent years and he feels their pain is now fully reflected in asset prices.

He highlights two interesting points. First, slow growth in emerging markets is a product of their deleveraging – they are paying off debt rather than investing in growth. Second, they are hugely influenced by wider global economics; bonds in the emerging markets began to factor in a US rate rise as far back as 2013 – an event known as the “taper tantrum” because a large proportion of emerging market debt is dollar denominated. Since then the dollar has risen strongly, which has kept US inflation in check. This in turn makes it more likely the Federal Reserve will keep any rate rises minimal, which is positive for holders of dollar-denominated debt.

There are three countries of particular interest in Mr Barrineau’s view: Brazil, China and Russia. Brazil shows no sign of improvement – its recession is getting worse and it can’t lower rates as inflation continues to rise. However, left in its arsenal is the ability to devalue the currency; that would make Brazil a poorer country but it would also make it more competitive.

In contrast, China has plenty of room to cut rates and more tools at its disposal than most to improve its economy.

Currency weakening in Russia has helped the country to deal with lower oil prices and it is now in a far better position to lower rates. Ironically, international sanctions have helped rather than hindered, with Russian sovereign debt performing better than all other government debt, according to Mr Barrineau.

The overriding message here is this: fixed interest isn’t dead. However, it is a difficult time to be investing in this area and investors need to be alive to different opportunities. As the views of these investors attest, the most interesting areas of the bond market are those usually viewed as higher risk.