Five burning questions on the Managed Fund: Bonds

Please remember that the value of an investment can fall and you may not get back the amount invested.

The Baillie Gifford Managed Fund offers investors access to our best ideas in regional equities and global bonds. The latter makes up around 20 per cent of the Fund and is there for both diversification versus equities (assisted by the five percent strategic allocation of cash) and the potential to add to returns. After a long period of very low interest rates, bond yields have rallied this year as rates have risen, creating opportunities for the active bond investor. This has led the Managed Fund team to increase the allocation to this asset class. Managed Fund specialist Philip Scott posed questions to the Fund’s bond team to hear about their outlook amid the prevailing doom and gloom in current markets.

Given the importance of inflation for bond yields, what is your view on inflation for the future?

We expect inflation to be more volatile than we have been used to over the last few decades. Globalisation and ageing demographics are two significant factors that have been disinflationary for a long time but are no longer so impactful, with globalisation going into reverse as production becomes increasingly localised. On top of this, there has been a succession of ‘one-off’ supply shocks; from the pandemic to the war in Ukraine. Central banks have raised interest rates to seek to control inflation, with the jury out on the success or otherwise of their actions. These supply shocks don’t last forever, so we expect inflation to calm down considerably from these very elevated levels, albeit to remain higher than we have seen since the Global Financial Crisis (GFC).

How attractive are bonds from an overall asset allocation point of view?

Having been quite unattractive for some time, the value of negative-yielding government debt soared in 2019. However, bond yields have since moved upwards dramatically to reflect the higher inflation picture and more aggressive central bank policy on interest rates. For example, yields available on investment grade corporate bonds are now the highest they’ve been since the GFC almost 15 years ago. This makes the overall investment case for bonds much more robust than it has been in previous years.

Previously, very low yields left little room for bond price appreciation (noting that as yields go up, bond prices go down and vice versa). However, from today’s starting point we expect a peak in inflation and policy rates would likely lead to a bond rally. This has led to some debate among the Managed Fund’s Policy Setting Group, which is responsible for overall asset allocation. Bonds are attractive from a return point of view, but a scenario where inflation peaks would also be good for equities. So it is not certain that bonds will do better than equities in the medium term. Considering the dual role of bonds in the Fund – diversification and return – we have been adding to the asset class from cash, albeit we remain slightly underweight versus the Fund's strategic asset allocation (19 per cent versus 20 per cent). We remain overweight in equities, given investor enthusiasm and the Fund’s overall objective of achieving capital growth over rolling five-year periods. The balance is held in cash.

Do government bonds offer any value now that yields have risen?

Yields on government debt have risen sharply over recent months. This uptick has resulted in US treasury bonds, for example, having their worst year on record in 2022. For active bond investors like us, these sharp movements in valuations provide opportunities in the developed and emerging market bond universes. For example, in developed markets, the Managed Fund invests in select US Treasuries. Despite recent commentary to the contrary, the US dollar and US government debt remain the global safe havens. In an increasingly unpredictable world, the capital preservation qualities of these bonds offer attractive portfolio diversification benefits. Within emerging markets Brazil has been at the front of the rate-hiking cycle, and its bonds offered a substantial yield of 11.9 per cent as at the end of October 2022. This is now one of our higher conviction positions within the bond portion of the Managed Fund and was a top contributor to overall fund returns in the 12 months to the end of October 2022. More broadly, central banks have shown they are willing to create a recession by raising policy rates to tame inflation. Government bonds should offer the best protection compared to equities or corporate bonds in that scenario. Therefore, they remain a key source of diversification within the Managed Fund.

Aren't corporate bonds too risky in this environment?

We believe current corporate bond valuations are increasingly compelling. High headline yields provided the opportunity to invest in high-quality companies’ bonds at attractive yields, with market uncertainty masking fundamental corporate resilience. Good examples include banks such as JP Morgan and NatWest, which have solid balance sheets thanks to tightened regulation following the GFC and are available at yields north of 6 per cent (as of the end of October 2022) – fantastic value for such robust businesses. There’s a strong possibility that higher funding costs at the lower-quality end of the high-yield market will lead to a rise in defaults. This is problematic if one owns the market, but we are active bond pickers and don’t hold anything we don’t want to. Never has it been more critical to select resilient companies where liquidity is strong and a sustainable capital structure is present.

In its entirety, at the end of October 2022, the corporate bond portion of the Managed Fund offered a 7 per cent yield. This is a tremendously rewarding opportunity for the long-term investor.

What opportunities are you most excited about in bond markets?

World central banks have responded to the current crises at different speeds, but the vast majority decided to raise interest rates. Within the government bond portion of the Fund, we have favoured the bonds of countries including Peru and Mexico where rates have been raised significantly and quickly. These countries offer exciting return potential as rates begin to come down and bond prices go up. Given the market backdrop, opportunities in the corporate bond world can come from what, on the surface, may appear to be mundane places. As an example, bulk annuity providers are substantial beneficiaries of high yields. While such companies don’t typically stir excitement in the average person, we’ve been extremely enthusiastic. These businesses, which seek to match pension liabilities with bond purchases, are forecasting much higher customer demand in the months ahead as more pension fund trustees buy bulk annuities. We believe the market does not fully appreciate this growth tailwind. Not only is it a positive signal of demand for corporate bonds more generally, but it should be very beneficial for the growth in scale and scope of bulk annuity providers. The Fund has taken advantage of this opportunity with recent new holdings in Rothesay Life and Pension Insurance Corporation. These are great examples of highly resilient businesses with clear paths for growth that offer excellent return opportunities.

The current uncertainty creates opportunities for active investors willing to look beyond the noise. We’re very selective about what is held in the Managed Fund’s bond portfolio in any market conditions, but especially when defaults are likely to rise. This gives us a meaningful edge and leaves us with much enthusiasm.

Important Information and Risk Factors

The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in January 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.

Custody of assets, particularly in emerging markets, involves a risk of loss if a custodian becomes insolvent or breaches duties of care.

The Fund invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.

The Fund’s share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.

This article contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this article are for illustrative purposes only.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

Past performance is not a guide to future returns

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