Bonds have continued to perform well as interest rate expectations and resultingly sovereign bond yields have come down. However, having come in somewhat in July, credit spreads widened as equity markets fell in August. Nevertheless, investment-grade bonds continue to provide a reasonable level of excess yield (spread) for the amount of risk being borne. Yet, the lower level of interest rates across the curve means that the absolute level of yield has come in significantly, making the asset class less attractive. The level of spread remains almost identical to the situation at the last rebalance. Given the increased level of economic uncertainty they should perhaps be a little higher.
High yield bonds have seen spreads widen somewhat better reflecting the economic uncertainty. However, again, we would expect that these should have risen further given increasing level of potential defaults. Given that high yield is the most exposed to greater economic stress, and our overwhelming preference for equities, we continue to avoid this sub-asset class.
Emerging market debt has become more attractive for investors in developed markets who have seen yields on their own sovereign bonds move sharply lower. It appears to be the beginning of a repeat of the first rounds of QE, where investors hungry for yield piled into EM debt, especially hard currency. This is unlikely to be an issue at this stage but may build into one over time.
Property has continued to do well as falling bond yields make real estate relatively more attractive and equities have risen. Predominately, our property exposure is through the passive L&G Global Real Estate Dividend Index of REITs. The fund has risen strongly over the recent past, benefitting from the falling Sterling as well as lower rates as discussed.
We have ensured that we have continued to review the sector, to summarise current thinking:
- We have maintained our passive REIT exposure across portfolio for just under three years now through the L&G Global Real Estate Dividend Index. This has been a good holding, however, we wanted to confirm that passive property exposure was the best way to gain exposure to the asset class. We are still of the opinion that direct property funds are not compatible with a daily dealing fund structure and therefore they have remained excluded from consideration.
- The question therefore is, are passive funds of REITs better than active ones? Looking at the past three years, the the fund that we use vs appropriate alternatives in the IA – Other Property sector, there appears to be little reason for us to change our stance at this stage. The fund has delivered returns that are better than three quarters of the sector, and a Sharpe ratio that is around the median. While the L&G fund does carry a higher level of vol than others in the sector, given the diversifying nature of the returns, this is not a major concern.
- Ultimately, for the limited upside available in picking an active REIT fund, the additional cost does not appear worth it at this stage.