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March 21, 2017

Fixed Income Funds: Sailing Calmly Despite Headwinds

by Jake Moeller.

Recently, Investment Week hosted its Market Focus 2017: Fixed Income fund buyers’ conference in London, exclusively showcasing a selection of bond funds. I expected this event might be a hard sell, with the U.S. ten-year Treasury reaching its 1.37% nadir last July, a brave new inflationary world pervading our geopolitics, and a good deal of central bank distortion.

Fund buyers appear calm

Surprisingly, the event (which, reflecting interest in the asset class, was extremely well attended) was characterised by a sense of calm–both among the buyers and the sellers. There was no talk of bubbles or mass sell-offs, and every presentation submitted compelling arguments that supported the asset class.

Exhibit 1. 20 Year History of 10 Year U.S. Treasuries (Yield Basis)

Source: Thomson Reuters Eikon.

Source: Eikon.

Flows into fixed income still robust

It’s fair enough to expect a certain amount of buoyancy for an asset class at a conference held in its honour, but it appears that European investors’ love affair with fixed income is far from over. Pan-European fund-flow data from Lipper reveal that global bond products were the most popular selling asset class for 2016, netting over €22 billion.

Indeed, of the ten top-selling fund sectors for 2016 bonds were represented in five of them, including emerging markets, global high yield, and global corporate–to the tune of some €70 billion.

Provisional data from the U.K. reveal that in the first two months of 2017 strategic bond funds and global bond funds are similarly proving popular, collecting nearly £1 billion net despite a small outflow for corporate bond funds.

Exhibit 2. European Fund Flows 2016 (€bn) – Ranked by Sector 

European Fund Industry Review 2016

Source: Lipper

Demand for yield can still be sated

Investor demand for yield is still a highly durable theme, and although the U.S. is tightening, “lower for longer” in the U.K. and Europe is still providing broad support. The average yield on Sterling high-yield bond funds is around 4.3%, which is undoubtedly attractive to many investors.

Furthermore, ratings migration within credit funds hasn’t materially increased in order to support yields. At the end of February 2017 the average exposure to BB-rated securities among Sterling high-yield funds was 39%, only a 5-percentage-point increase from 2012.

No sense of panic, but no clear outlook either

Unfortunately, there was no uniform outlook for bonds among the specialists at this fixed income conference, and I did not envy the asset allocators who had to go re-calibrate their bond and equity splits. Most of the fund managers agreed that the credit cycle was extended, but that it could be undone with geopolitical shocks.

Many were short duration and others were writing put options on their portfolios. Some believed that too much was being priced into the reflation story, some talked of stagflation, and others were concerned about U.S. interest rates and the appreciating dollar.

The beta play is over

There was, however, one theme that stood out on the day: the easy bond beta play is well and truly over.

For me at least, this was perhaps the most rewarding insight. For an asset class where many investors will have an itchy trigger finger, an active fund that is cherry picking in credit, avoiding huge duration calls and the crowded trades is probably a sensible place to sail if the weather becomes more inclement.

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