— Jun 11, 2014

A vast pool of liquidity has been thrown at the global economic system by the central banks since the credit crunch.  One of the results has been flattening of all yields and general asset price inflation.

A question that is increasingly being asked is, what corner of what asset class might provide the best shelter when the liquidity injections are turned off and the world’s interest rate systems return to normality from their current near zero levels?

Historically, the first place to look for security and a small yield has been the government bond or gilt market.  Offering a guaranteed return of the principal at expiry and a regular coupon, these bonds have been the bedrock of the low risk portfolio. The returns had been low, but so had the risk. Pre crisis, a yield to maturity of 5% for a short or medium dated gilt was possible.

For today’s investor looking for a safe haven in gilts, they face close to zero yield to maturity in the very short dated gilts, rising to only 3% if they go further out towards long dated gilts.  Speculation of the Bank of England (BoE) positioning expectations of a rate rise coming sooner than expected has led to an accelerated rise in yields and fall in prices of medium term gilts.

We expect the volatility of bond prices to increase as the BoE’s life support machine for the economy is slowly turned off and rates are inched up.  What options do you have if you wish to avoid large price volatility in the low risk end of a portfolio?

An option that should be explored is the specialist fixed income fund managers who specialise in high grade asset backed bonds.  Asset backed securities, with the excess leverage that was mixed in, rightly got a terrible press with their role in the sub-prime disaster.  However, prior to that, they had been dominant in the lowest risk and lowest return end of the investment world.  We see funds now specialising in this low risk, low return asset backed debt as a potentially beneficial addition to a defensively positioned portfolio.

It is unknown how the bond markets will react when the Bank of England eventually downgrades its unprecedented current intervention. It may be a smooth, slow transition to the previous rate curve.  However it may also be disorderly and violent.  Now is the time to be absolutely clear what interest rate exposure is acceptable and to evaluate the downside if or when the levee breaks.