Income-seekers must face the duration test

The latest figures from independent consultant ETFGI which show cash barrelling into fixed income Exchange-Traded Funds (ETFs) serve to confirm the scramble for income remains as acute as ever. The data reveal net global flows of $13.3 billion in January to the third largest month on record for the asset class.

Equities suffered outflows while commodities also had a strong month as stock market volatility picked up. Investors may therefore be seeking some security, as well as income, from bonds and some diversification with raw materials, where braver souls may have also started to bottom fish after the fourth quarter price rout.

Yet even fixed income is unlikely to be a one-way street forever, especially after a 30-year bull run and with interest rate hikes potentially on the way from the US Federal Reserve this year and the Bank of England next. Investors looking to keep their exposure but manage their risk could consider bond funds with a flexible mandate or those where emphasis is as much upon capital preservation as it is income accumulation.

One example of each here can be found with M&G Optimal Income and AXA Sterling Credit Short Duration respectively, both of which are positioned for a gentle increase in US interest rates, starting this year, based on this column's recent meetings with them. The former lies in the Sterling Strategic Bond category (IA Sector GBP Cautious Allocation) and the latter the Sterling Corporate Bond segment, according to Morningstar, although neither operates with an index in mind and both target the optimal risk-adjusted total returns, albeit in a quite different way.

Not all of their sector peers operate in the same way and some come with equity exposure. Investors will need to look closely at individual funds in these areas to ensure they fit with their own individual investment goals, risk appetite, time horizon and target returns. The tables below highlight the strongest performers over the past five years in each arena.

The top-performing GBP Cautious Allocation funds over the past five years

Source: Morningstar, for GBP Cautious Allocation category. Where more than one class of fund features only the best performer is listed.

The top-performing Sterling Corporate Bond funds over the past five years

Source: Morningstar, for GBP Corporate Bond category. Where more than one class of fund features only the best performer is listed.

Flood of cash

The gallop for reliable income was a subject discussed at great length by leading member of BlackRock's fixed-income team at a briefing in London earlier this month. Stephen Cohen, Chief Investment Strategist for the Fixed Income and iShares International teams, flagged three trends that he and his colleagues had seen in 2014 when, to use his words, the hunt for yield accelerated.

• Growth in demand for unconstrained and flexible bond funds
• Active client interest in multi-asset income funds
• Strong demand for fixed-income ETFs, where Cohen flagged $85 billion of global inflows for all product providers in 2014

A quarter of that ETF cash sloshed into the high- and investment-grade areas, according to Cohen, areas where yields are thin and getting thinner. Any clients wanting to bag some extra yield, in exchange for some extra risk, will increasingly find themselves obliged to look at corporate high yield or emerging market (EM) bonds. Of this pair, the latter looks to be more of a contrarian play, especially as a Reuters report (29 Jan 2015) cites research from BNP Paribas that warns a tenth of sovereign and emerging market debt – or some $260 billion – faces relegation to 'junk' status by the ratings agencies. In addition, $1 trillion of EM debt is ranked BBB or BBB-, just two and one steps from junk.

Bondholders are exposed to three main risks:

• Credit, issuer or default risk
• Interest rate, or market, risk
• Liquidity risk

It can be argued EM offer plenty all three, if the BNP Paribas analysis is any guide. Even though Jan Dehn of Ashmore continues to strongly argue the yields on EM debt, and spreads over the Western equivalent, more than compensate for the additional dangers, some investors may prefer to get their bond exposure closer to home, especially as fixed-income investing is supposed to be about restful nights, not sleepless ones.

The question then is how to prepare for shifts in interest rates. Should anyone take the view there is no need to do so, and rates are going to stay unchanged for long period of time, then they can possibly move on addressing other issues. In 2014, the market consensus was interest rates would go up and bonds, especially long-duration bonds, would get killed. In the end, rates did not go up and the best performing asset class in fixed income was bonds with 30-year or more time horizons, as evidenced by stunning 30%-plus total returns from long-dated Treasuries in the USA, Gilts in the UK and bunds in Germany.

Long duration bonds confounded bears in 2014

Source: Thomson Reuters Datastream

George Osborne made holders of the 3.5% UK War Loan paper very happy with December's Autumn Statement as he sanctioned the paper's redemption at par. This perpetual paper, which dated back to 1932 and had no maturity date, was redeemed at par, having traded at a very big discount for a very long time.

The UK's redemption of the 3.5% War Loan have holders a nice capital gain

Source: Thomson Reuters Datastream

Meanwhile, sharp-eyed readers will also notice the presence in the table of best performers from the GBP Corporate Bond category of a long-dated corporate bond fund from AXA.

Margin of safety

Yet as spreads compress and yields get thinner, the buffer on offer against any potential capital loss in the event interest rates do rise is getting progessively thinner. This is where duration comes into play as a means of measuring how to best obtain the optimal risk-adjusted returns.

• Macaulay duration measures the average weighted time to maturity of all coupon and principal payments
• Modified duration quantifies interest rate risk and how much a bond or portfolio of bonds will move in price relative to a 1% shift in borrowing costs.

In crude terms, if a 10-year corporate bond has a duration of 9 years, the price of the bond will move by around 9%. The relationship is not entirely linear but the dangers ar clear - a 9% move in a bond's price on a 1% interest rate hike might not sound a lot but it is if that bond's yield is just 4.5% at the price a client or fund manager paid for it in the secondary market. That is two years' worth of income flushed away so measuring the risk of capital loss on any bond holdings is vital, especially anyone is planning to sell before they reach maturity to meet any cash needs you may have.

This is where a bond fund can help, especially one with a flexible mandate which allows it to tackle – and even benefit from – the issue of duration. In general,

• Longer-dated bonds have longer durations, as the returns are more back-end loaded, so they will be more volatile, or sensitive to interest rate movements. Perpetual bonds, with no maturity date, are the most volatile bonds of all.
• Lower-coupon bonds also have longer durations, and therefore be more volatile, as again the returns are more back-end loaded. Zero-coupon bonds have a duration that is the same as their maturity.
• The opposite also apply, so the shorter the life of the bond, or the higher the yield, the shorter the duration.

Investors may therefore consider the flexible bond angle highlighted by BlackRock or investigate a portfolio where the money managers have a flexible mandate which enables them to tackle – and even benefit from – the issue of duration.

For example, Gordon Harding of M&G's fixed-income team explains all bond fund managers must know their neutral duration position. At the moment, for a Gilt it is 10 years, sterling investment grade corporate deb) eight years and high yield three-and-a-half to four years. A 'neutral' portfolio split equally across those three asset classes would give a duration of six years, yet the M&G Optimal Income portfolio currently has a duration of around two-and-a-half years. This reflects a cautious view on Government bonds and a more bullish one on corporate paper - though this could be wrong-footed to a degree if the world turns Japanese and sovereign yields grind lower still. In this case the fund would benefit, just not as much as some of its peers.

Balanced approach

A different approach is taken by the AXA Sterling Short Duration fund, where manager Nicolas Trindade's focus lies with corporate bonds that have less than five years to maturity and the large majority of the holdings are investment grade. The low duration and modest exposure to high-yield paper, currently barely 3%, offer some protection from any increases in rates. Trindade looks to beat cash by providing consistent incremental total returns while offering security and he argues his fund's structure means it will capture 60% of any upside and 40% of any downside, which may appeal to risk-averse, income-seeking investors.

M&G Optimal Income's performance since inception

Source: Thomson Reuters Datastream

AXA Sterling Credit Short Duration's performance since inception

Source: Thomson Reuters Datastream

Ultimately, a durationless fund could be achieved, through hedging or even short positions, and unconstrained bond portfolios may look to achieve this. Harding does not see M&G Optimal as unconstrained and such a tactic is largely untested, as rates are still grinding lower, although the M&G and AXA funds outlined above were established nine and five years ago respectively, so the challenge of rising rates is yet to be faced here as well (assuming it happens).

The skill of the managers will prove paramount when the test of a rate rise comes, no matter how well flagged it is likely to be, and it is then that they will earn the fees that do, in the end, chip away at the yields and capital gains they seek to generate for investors. In the case of the flexible M&G fund, Harding accepts there is more risk involved, as there has to be, since the mandate is to generate total returns, so the team there will have to take a view to do just that.

Russ Mould, AJ Bell Investment Director