Dexia’s Ken Van Weyenberg considers how to get the most out of bonds

Ken Van Weyenberg, investment specialist at Dexia Asset Management has outlined the options for fixed income investors at a time when government bonds have become expensive and downside risk has increased.

Bonds have performed impressively over the past 20 years and in recent times European and American government bonds have posted double-digit returns, as a result of actions taken by central banks and the widespread flight to quality. In the wake of the huge rally in 2011 and 2012, however, government bonds are now relatively expensive and the upward potential has become limited, while the downward risk has increased significantly. In such a climate, how can investors get the most out of their balanced bond portfolio?

The first step for investors is to look at the bond length of their balanced portfolio. Investors can protect against the potential negative impact of interest rate volatility at a time of historically low rates by shortening their durations. For example, in the case of European government bonds (based on the JP Morgan EMU Govt. Bond Index) an immediate rise of 1% would have a negative impact on prices of almost 6.4%. Taking the expected yield of European government bonds of approximately 2.6% into account, European government bonds would show a negative yield of 3.8%. Shortening the average duration of the bonds in the portfolio, however, can limit this impact. However, on a shorter term we have a more cautious stance following Cyprus events and due to the gloomy macroeconomic environment. That could be supportive for safe havens, such as the German bund.

In addition to a shortening of duration on the mid-term, the next key step for investors is to work towards a strong diversification across those segments of the market that are particularly attractive at present. The key issue is identifying which types of bonds to use.

Due to investors being in ‘risk-on’ mode, investment grade corporate bonds are attractive because they can benefit from current market conditions. Such instruments already reflect the slower expected economic growth, but due to a fairly limited risk premium, it is necessary for investors to search for foreign currencies that can offer an attractive carry. Of course, in doing this investors must be aware of how to best manage the currency risk associated with foreign exchange rate exposure.

Elsewhere, bonds from emerging countries should remain on the radar of investors. Emerging markets are commanding an increasingly dominant role in the world economy, but they are still a long way from their full capacity and they are still capable of achieving sustained growth. It is worth noting that the average creditworthiness of the emerging countries has now improved to BBB- (Embi Global Diversified Index) and the relatively low debt ratio to GDP is still falling. While it makes sense that the yield difference with government bonds has fallen sharply in recent years, bonds from emerging countries in USD are still offering an attractive additional yield of 2.70%.

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