Partner Insight: Jonathan Platt, Head of Fixed Income at Royal London Asset Management, discusses the challenges of a low yield environment and why it is important to have diversified exposure across the fixed income universe.
Our key message to investors is that in the UK, and throughout developed economies, the neutral interest rate is now much lower than it was before the great financial crisis and therefore we would expect rate rises to be limited and gradual. Making this mental adjustment to a new normal is difficult, especially if investor perceptions of inflation and interest rates were founded in a different economic environment.
The contributing factors to the new conditions include: globalisation, the increasing influence of Asia on macroeconomics and less flexibility for central banks to raise rates given elevated personal debt levels in developed economies.
Consequently, we expect modestly higher bond yields as long as we do not see a significant change in the political direction in the UK. A second theme that managers are often reluctant to acknowledge is the difficulty of dealing with uncertainty. Without uncertainty there would be no markets, so uncertainty is central to what we do.
At the present time the heightened uncertainty in the UK around Brexit, the growing gulf between political vision of Britain, Europe migration and the viability of the Eurozone are the key issues. Consequently, bonds play an important role in portfolio diversification given the difficulty of predicting outcomes to issues and how markets react.
Diversifying credit exposure
Diversification is a third theme to look at within bond markets as investors are generally paid to take credit risk, if specific risks are sufficiently diversified. A recurrent theme of credit bond investing is that investors are generally over compensated to take default risk. Now there is more than just default risk that goes into the yield premium of credit bonds over government debt; other risk considerations are liquidity and credit rating migration risk.
But fundamentally it is the default risk that is paramount. For investment grade bonds the yield premium required to compensate for default risk is less than 0.4% (based on historic default and recovery rates). At the present time the average credit spread for investment grade sterling bonds is an attractive 1.25%.
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