Driven by very low deposit rates and low yields on government bonds, investors have been piling into corporate bonds. In the first half of 2014, inflows into bonds totalled some $273bn (£1.64bn) compared with $222.9bn (£134.3bn) into equities, while money market funds, which are a proxy for cash, suffered outflows of $112bn (£67.5bn).
Last year, the inflow was into high-yield junk and government bonds from the peripheral eurozone countries such as Portugal, Spain and Italy.
This year, the inflow has switched to investment grade bonds as strong inflows pushed down the yields on euro bonds. Many big corporates have taken advantage of this demand to issue new bonds, which has further fuelled demand.
The value of European investment-grade corporate bonds issued recently have topped $20bn (£12bn), the first time it has done so for nearly five years, according to Dealogic.
In the UK, the inflow has seen a number of bond funds grow rapidly in size; Richard Woolnough’s M&G Optimal Income fund has now passed £20bn. In the three months to 31 March, the fund took in a net £2.1bn, according to FE estimates, compared with £3.3bn over the previous nine months.
The growth in bond funds and the high levels of inflows have caused enough concern for the regulator to raise concerns about liquidity in the market, and fund managers such as Richard Woolnough have been forced to defend their funds.
The inflow has been in spite of a slight flattening of the yield curve in 2014 (although there has been little movement at the short-dated end of the market) and increased volatility following the concerns around slowing of US quantitative easing last year.
So what should investors be doing? First of all, asset allocation should drive investment decisions rather than yields or market timing. Diversification is important and bonds have an important role to play.
However, it is important to remember that while bonds can provide some returns (as they have done over the past few years), their main function in a portfolio should be to reduce volatility and provide a counterweight to equities as can be seen in Chart 1.
At times of extreme volatility in equity markets, typically, fixed income assets will rise in value and counterbalance the falls in equity prices, as they did in 2008.
Real diversification, however, works best between high-grade investment bonds/gilts and equities. High-yield bonds and equities are much more closely correlated, and should be viewed as part of your risk segment than the defensive part of the portfolio. In 2008, many high-yield bonds fell by as much as the more defensive-placed equity funds.
Secondly, it is important to remember that just as sub-sectors and geographic regions in equity markets have different cycles, the bond market is not uniform. It therefore pays to be geographically diversified within your bond exposure.
Data shows hat while the UK and US bonds have followed a close pattern, returns from European bonds vs UK/US bonds have greatly diverged. Overall returns would have been smoother if a portfolio has exposure to all these markets.
