2016 is obviously going to be remembered as a year of great change from a political point of view, but it also could go down as the end of the great bond bull market, which has spanned the best part of three decades.

A credit boom in the decades prior to the global financial crisis coupled with significant market intervention from central banks since the crash (in the form of ultra-low interest rates and vast levels of quantitative easing) has seen bond yields fall, and therefore bond prices rise, continuously since the 1980s. In turn, this has led to almost unprecedented risk-adjusted returns for fixed income investors.

Over the past 30 years, for example, the FTSE Gilts All Stocks index has returned 893.15%. While that is lower than the return of global equities (as measured by the MSCI World index), gilts have posted a maximum drawdown – or the most an investor could have lost if they had bought and sold at the worst possible times – of just 10% over that time, which is four times lower than the largest potential loss delivered by equities.

Source: Morningstar

In more recent times, thanks mainly to action from central bankers trying to reinvigorate their respective economies, this trend has had knock-on effects for equity markets, with ‘safe’, high-quality, dividend-paying stocks being lapped up by ‘tourist’ bond investors looking for some form of acceptable income as yields have been driven to historic lows. As such, top-performing equity managers over recent years including Terry Smith and Nick Train owe much of their table-topping numbers to this bond bull market.

 

The end of an era?

However, recent events suggest this could all be about to change. Having started 2016 with another almighty drop, government bond yields have risen dramatically since August to the end of December (to the tune of 95%, according to FE Analytics). In the case of UK gilts, this has been driven by Brexit uncertainty and the pound’s collapse (which, in turn, is pushing through higher levels of inflation), as well as a significant rise in US treasury yields – a trend which has been spurred on by the election of Donald Trump and his commitment to economic stimulus.

Though many have incorrectly called the collapse of the bond market for a number of years, neither of these two powerful forces (Brexit and Trump) are going to go away anytime soon, so it is understandable that certain professional investors believe that global bond markets will continue to come under pressure. Such a trend would mean a big upheaval to what has become the status quo and continuously rising bond yields would cause headaches for most investors (given that the strong risk-adjusted returns bonds have delivered have created somewhat of an asset allocators’ paradise).

However, our research shows that value investing – a style that has been out of favour for the past decade – has tended to outperform during times when bond markets have corrected. With the usual caveat the past is no guide to the future, in this research we highlight four trusts in the particular that have tended to benefit during such conditions.

 

Value’s big resurgence?

The value style had suffered over the recent times thanks to this period of ultra-low bond yields combined with an overarching sense of nervousness that has continued to dog investors since the global financial crisis. On the other hand, growth investing has been very much in favour as the market has rewarded companies that can grow in what has been a low-growth world, but also because ‘growth’ indices include those so-called bond proxies (companies with dependable earnings and a safe dividend) which have benefitted from the Bull Run in fixed income. The MSCI UK Growth index’s top 10 constituents include top performing ‘Steady Eddies’ like Diageo, Unilever and Reckitt Benckiser, for example.

Source: FE Analytics

 

However, we have analysed the relationship between these two investment styles during periods when bond yields have risen in the past.  For our research, we have looked back at that the 19 periods (priced daily) over the past 20 years (to the end of December) when 10-year UK gilt yields have risen more than 20% and analysed the performance of the value indices versus growth and all-encompassing indices.

According to our research, the MSCI UK Value index has beaten the MSCI UK Growth index in 12 of those periods and has beaten the wider MSCI UK index in 13 of them. That is, of course, not outstanding. However, as the chart below shows, over those 19 periods on average, the value index has doubled the return of the growth index (with an average gain of 6.34%), beating the wider equity market by a decent margin in the process.

Source: FE Analytics

It is a similar story when we analysed the performance of the respective MSCI AC World indices.

 

The bigger the rise…

Interestingly, though, value’s outperformance has only been marginal when gilt yields have risen by 20% to 30%.

Source: FE Analytics

 

This has happened in nine of the 19 periods we analysed and, on average, the MSCI UK Value index has returned 4.44% compared a gain of 4.24% and 4.37%, respectively, from the MSCI UK Growth index and the MSCI UK index. In fact, from a global perspective, the MSCI AC World Value index has narrowly underperformed the MSCI AC World Growth index on average over those periods.

Instead, it is when the bond market has completely fallen out of bed that value investing has really come into its own. Over the 10 periods when UK gilt yields have risen by more than 30%, the MSCI UK Value index has outperformed growth in seven of them, returning 8.06% on average. This compares to a return of 5.79% from the wider UK equity market and a meagre gain of just 2.28% from the MSCI UK Growth index. As such, and though there is no guarantee this will continue, this that investors have been able to shield their portfolio against the negative impact of a bond market sell-off by allocating to the value style.

These periods also include the most recent spike in yields caused by Brexit uncertainty and ‘The Donald’. Between September and late December, 10-year UK gilt yields rose by 95% (from 0.74% to 1.45%) and, thanks to increasing correlations between the growth index and bond markets (0.54 over 12 months, compared to -0.08 over 10 years), the MSCI UK Growth index lost 4.19%. The MSCI UK Value index, on the other hand, returned 6.49%.

Source: FE Analytics

 

This performance pattern is again reflected from a global perspective (albeit it by a smaller margin) with the MSCI AC World Value index outperforming by a decent margin over the periods when bond yields have risen dramatically.

 

Getting the most out of value’s resurgence…

Value’s revival started in February last year as areas such as mining, oil stocks and banks rebounded from a painful 2015 and another sharp sell-off in January 2016.

As such, many investors may look to allocate to a cheap value ETF to take advantage of this trend. However, as a part of our research, we found that certain active managers with a clear value-bias have managed to deliver superior returns to the index during those periods of rising bond yields.

One of the best examples is Fidelity Special Values, which was launched by star manager Anthony Bolton and is now run by Alex Wright – who follows the same distinctive contrarian style as his famous predecessor. The trust has a good long-term track record in its own right, but has come into its own during previous bond market sell-offs.

Over the 19 periods in question, Fidelity Special Values has delivered an average NAV return of 9.56% and, given its discount has narrowed (again, on average) to the tune of 98 basis points over those times, investors have witnessed a share price return of 11.51% on average.  As with the performance of the value index, this trust has also delivered greater returns when gilt yields have risen by more than 30% in the past (11.08% in NAV terms and 14.45% in share price terms).

Source: FE Analytics

Alex’s approach is highly contrarian. He looks to identify out-of-favour stocks with potential for positive change and limited downside risk. He searches for opportunities across the entire spectrum of market caps within UK listed companies, with a bias towards the smaller end of the UK market.

To read our latest detailed note on the trust, click here.

Another UK trust with a strong long-term track record of outperformance, particularly in periods when bond yields have risen, is Aberforth Smaller Companies. It is a trust with a long-serving and stable management team, which invests in a portfolio of around 80 UK smaller companies, using fundamental analysis and face-to-face meetings with company management to identify businesses which are significantly undervalued, favouring those which have net cash on the balance sheet to avoid ‘value traps’.

Source: FE Analytics

 

Its focus on the smaller end of the UK market would naturally lead it to superior returns to the wider index over the longer term, but it too has significantly outperformed when bond markets have come under pressure – delivering NAV returns of 12% and share price returns of 13% when 10-year gilt yields have risen by more than 20% in the past. Like with Fidelity Special Values, the larger the bond market sell-off, the more the trust has outperformed.

To read our latest detailed note on the trust, click here.

There isn’t a great deal of global trusts that follow a true value approach apart from British Empire, which is highly differentiated from its peers, not just because of its value-tilt, but because its investable universe is predominately family-controlled holding companies and other closed-ended funds.

It has a long-term track record of outperformance, but had struggled due to its value style (and its historical underweight to the US) between 2012 and 2015. However, it too has significantly outperformed when gilt yields have risen by more than 30% in the past (as the chart shows, with share price returns significantly higher than NAV returns as its discount, on average, has narrowed by 1.63 percentage points over those periods) and so it comes as little surprise that the trust significantly outperformed last year, a period when bond markets corrected.

Manager Joe Bauernfreund’s investment process boils down to not only finding companies that are trading at discounts to NAV, but also have good potential to appreciate in value, and with an identifiable event or corporate catalyst which would serve to reduce or eliminate that discount.

To read our latest detailed note on the trust, click here.

The final trust on this list operates in the market where value investing was born – the US-focused Gabelli Value Plus Trust.

The trust itself was only launched in 2015, but it follows the same ‘Private Market Value with a Catalyst’ investment approach (which was built by Mario Gabelli, who co-manages the trust) in the 1970s. The strategy is based on classic Benjamin Graham and David Dodd-style value investing, but with a difference. The managers seek out companies whose share prices are trading at a discount to what they deem to the private market value of that given stock (which they describe as a ‘margin of safety’). They will, however, only buy companies where they see a catalyst for that value to be realised including the likes of spin-offs, management changes, tax reforms and financial engineering.

For our research, we tested the strategy (which has delivered strong long-term returns relative to the S&P 500 over the long-term) via the Gabelli Asset Fund, which was launched in the 1980s. Again, not only has it outperformed during periods of rising bond yields, but particularly when government bond markets have sold off significantly (it has returned 8.17% when yields have risen by more than 30%).

To read our latest detailed note on the trust, click here.