12 Oct 2023
Despite being a bond manager, Artemis’ Head of Fixed Income Stephen Snowden has always preferred to buy equity funds for his personal portfolio. But with good-quality short-duration bonds generating more than 6% a year, he says it makes sense to lock these yields in.
This year, for the first time ever, I have invested my ISA money in my own bond funds – primarily the Artemis Target Return Bond Fund and the Artemis Corporate Bond Fund. I have owned ISAs since they were “PEPs” nearly 30 years ago, so that may take some explaining.
It is not that I have never “eaten my own cooking”, as they say in the industry. I’ve invested for strategic reasons in the past – to help get a fund started and show my commitment. But this is the first time I’ve chosen to go for bonds for pure personal investment reasons.
You could suggest that I am going through a mid-life crisis. It made no sense to be a fixed income investor when I was 24. Now I am 51, might I be lifestyling my portfolio, boosting my exposure to bonds because that is what you are traditionally told to do as you age? That was not what drove the decision.
Impact of QE
Let’s start with my view of the world. If you think about quantitative easing (QE), it drove bond prices higher and yields lower. As the risk-free rate fell, investors turned away from buying bond funds in favour of equities. I know, because trying to persuade institutional investors to buy my strategies when bond yields were so low was hard work and I like to think performance was not the issue!
Meanwhile the low cost of capital was enabling firms to borrow cheaply to invest in growth and investors to tolerate no returns, piling into stocks promising a bonanza further out, sending price earnings multiples up. As a result, I believe the asset class that benefited most from QE was equities.
Now that QE is unwinding, this is reversing. As yields move upwards, the risk-free hurdle that equities have to jump to deliver superior returns has just got a lot higher and so, therefore, has the risk of them failing.
Investors are no longer so enthusiastic about overpriced young tech companies costing the earth, promising the moon and unlikely to make money for years. If ever. Yield is becoming a more important component of total returns for portfolios again.
Equity risk
Equities face tough headwinds. There is a serious danger that central bankers will miscalculate and turn the interest rate screw too tight, sending the global economy spiralling into recession. So many people are on fixed-rate mortgage deals that the full impact of rising rates has yet to be felt. I have lost count of the number of people I meet who are facing a huge hike in mortgage costs when a deal ends within the next six months. What will happen when this feeds through? It seems implausible to me that we could go from base rates of practically zero to 5.25%1 without consequences.
You could argue that we have already seen the consequences with the demise of Credit Suisse and Silicon Valley Bank and that a soft landing now lies ahead. If so, the central banks have all done a triple-axel jump and landed on the ice beautifully. I think it is too early to fill in the score cards on that tricky manoeuvre.
Central banks are still managing the end of the era of QE. Less noticed, another era is also ending. Historically, we have seen global growth rates correlate very closely with the increase in the global population. Economic growth is the biggest driver of stockmarket returns. Fertility rates have been falling in many jurisdictions for some time, and Covid seems to have accelerated that. This is likely to lead to a slowing or slower-growing global economy.
This is the backdrop for equities. Meanwhile, in fixed income you are now being enticed by that big, fat yield. Good short-duration bonds generate over 6%2 a year currently. You’ve got to be pretty bullish on the economy to think equities can beat that – or else in your 20s with a very long-term view, which is not me anymore!
Why not cash?
You might say that NS&I is offering over 6%3 now, so why invest in a bond fund where there is still an element of investment risk?
The NS&I rate is a one-year deal. I think inflation will come down in the coming months. By buying into a bond fund now you are locking in that high return for three to five years or so – better than you’ll get in most cash savings accounts if interest rates plateau and fall.
Indeed, you might consider an investment in bonds insurance in your portfolio against a global economic slump, because if that happens central banks are likely to slash interest rates pretty quickly to jump-start it back to life. Locking in those yields now could look to have been a very smart move.
I am not banging the table saying bonds are guaranteed to outperform equities over the next one to five years. But I am saying that the likelihood of equities substantially outperforming bonds, when yields have risen so dramatically, is lower.
In my opinion, it makes a lot of sense for many people who are very heavily invested in equities to consider the balance of their portfolios and to take the chance to lock in those attractive returns from fixed income now. I have.
1 The Bank of England
2 Fund manager’s portfolio
3 NS&I
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