2018 Isa fund tips: Experts are bearish on bonds – here’s how to invest safely

Monetary policy has supported bond markets for a decade. Low interest rates and low inflation have seen bond investors enjoy many years of gently rising returns. 2017 was the year this benign environment finally started to reverse: interest rates went up in the UK and US, and the eurozone started to discuss scaling back its quantitative easing (QE) programme. At the same time, inflation – the old enemy of fixed income – began to rear its head.

Tough year never materialised

With this in mind, it should have been a tough year for bonds, but it wasn’t. Admittedly, investors might not be exactly thrilled with the 0.1 per cent average return they have seen from their gilt fund. The average global bond fund also failed to deliver a return ahead of inflation (3 per cent in October), dampened by the weakness of sterling. However, investors were likely better pleased with the average 4.4 per cent return from their sterling strategic bond fund and quite happy with the 5.1 per cent achieved on their high-yield bond fund.

Torcail Stewart, manager of the Baillie Gifford Corporate Bond fund, says: ‘High yield has done well since the start of 2017. Spreads over government bonds have compressed.’ This has been helped by a generally supportive corporate environment: default rates have been low and earnings relatively buoyant.

The same has been true for emerging market debt, where investors have seen average returns of a little over 4 per cent. At a time of ongoing low rates, the higher income available on high yield and emerging market bonds has appealed. Eric Holt, manager of the Royal London Sterling Extra Yield Bond fund, says the income yield has been vitally important in determining which bonds have done well.

Even at the ‘defensive’ end of the market – developed market government bonds and investment grade corporate bonds – the returns have perhaps been stronger than investors might have expected given the environment. There was no significant sell-off, even in the face of shifting inflation expectations. For the time being, bond markets have again defied the naysayers.

However, while this was said last year, and probably the year before and the year before that, this benign environment cannot last indefinitely. Looking ahead to 2018, Holt believes it will be difficult to sustain the relatively tranquil environment of 2017 and he is expecting far greater volatility. He says: ‘There is no lack of challenges – from the economy, from politics. We believe markets will be quite thin and skittish. We are already seeing much more intra-day volatility. But volatility is no bad thing, though it may feel like it.’

There are certainly no bargains. Yields remain at record lows (and therefore prices at record highs) relative to history, and the potential for significant returns from here is limited across fixed income markets. Stewart has been moving away from high yield as it has become progressively more expensive. He says opportunities, where they exist, are idiosyncratic and selective. ‘We are focusing on our “best ideas”,’ he adds. ‘These are companies with a strong business model, that are grinding out a higher income.’ They are evident in sectors as disparate as US high-yield bonds, bank bonds, asset backed securities and some retail corporate bonds.

That said, while there isn’t much to get excited about in bond markets, there probably isn’t much to fear either. Inflation, for the time being, appears to be under control and there are few signs of rising interest rates. Stewart says: ‘There are strong deflationary forces to prevent inflation. There are economies of scale in the corporate world. If you look at the long-term thinkers, such as Masayoshi Son, the founder and chief executive officer of SoftBank, we are still only scratching the surface of what technology can achieve. Technology reduces labour’s bargaining power over the longer term.’

He points out that even in countries such as Sweden, which has seen quantitative easing, a strong economy and credit growth, inflation is very low. ‘This is not an environment where we are likely to see sudden rises in rates,’ he adds. After the recent rate rise, long-term gilt yields actually fell slightly. This isn’t what should be expected, but the market reacted to the Bank of England’s dovish view on future rate hikes.

Stewart believes that there may be a ‘behavioural’ correction in corporate bonds at some point: ‘People still have the financial crisis in the back of their minds. I don’t believe this correction would last long – the global economies are ticking along nicely and there may still be tax reform in the US. As such, the risk of defaults in the corporate bond market is still quite low.’

Experts are bearish on bonds

This backdrop has led expert fund selectors to favour those bonds with a little more flexibility. Darius McDermott, managing director at Chelsea Financial Services, says: ‘Like most, we have been underweight fixed income for a while now. Yields are too low, and bonds have been supported by quantitative easing, which is coming to an end in most parts of the world.

‘If you add in the fact that inflation in the UK has been stubborn and that the oil price has risen, it doesn’t look positive for fixed income moving into 2018. Rate rises have been signposted.’ The group is currently recommending funds with a lower interest rate exposure, such as the AXA Sterling Credit Short Duration, and those that aim to make money in all market conditions, such as the TwentyFour Absolute Return Credit fund. McDermott also likes emerging market debt because of the higher yields available.

Gavin Haynes, investment director at Whitechurch Securities, says: ‘One of the greatest challenges for us is bond markets and where to find value in a rising interest-rate environment. The recent UK rate rise is the first since 2007, but the concern over rising interest rates has seen the gilt rally run out of steam and they posted negative returns in 2017. We have been avoiding gilts on valuation grounds for some time, with yields providing a negative real return.

‘Going into 2018 we continue to believe that the risk/reward trade-off for investing in conventional government bonds is unattractive on valuation grounds, but we don’t see bond prices collapsing. A global approach makes sense when investing in bond markets with economies at different stages of the interest cycle. We continue to prefer corporate bonds, and particularly funds using special situations such as bonds of financial companies. We look for funds that have a “go anywhere” global approach and have been introducing an element of emerging market debt where risk tolerates it.’ He likes the Jupiter Strategic Bond, as a well-diversified fund with a flexible mandate.

What will be the big influences for the bond market in 2018? Stewart says US tax reform will be closely watched by fixed income markets. The stability of the European Union may be exposed by the Italian elections, and this will be another important point of focus.

Holt concludes: ‘The fundamental challenge as we see it is the underlying yields on government bonds and how they contrast with expectations of what is a credible return. In many cases, bonds are generating an income simply to replace lost capital. Sterling corporate bonds look attractive over gilts, but gilt yields are so low. The key is that managers need flexibility to find value.’

Our panel of experts give fixed income and multi-asset tips

M&G Global Macro Bond (flexible income)

TR 1 year 3.9%, 3 years n/a, yield 2.2%

Our panel view manager Jim Leaviss as one of the best bond managers. Rob Burdett likes the fund’s broad mandate, while Brian Dennehy adds: ‘There are two ways to make money in global bond funds – the bonds and the currency. This fund exploits the currency angle better than most.’

Henderson Strategic Bond (flexible income)

TR 1 year 6.7%, 3 years 13.3%, yield 3.8%

Another bond fund with a flexible mandate. Jason Broomer says the fund manager duo of John Pattullo and Jenna Bernard have proved adept at managing bond funds in the prolonged low interest-rate environment. He adds that the go-anywhere remit hands the managers the best opportunity to perform regardless of the wider market environment.

M&G Global Floating Rate (tactical pick)

TR 1 year 4.3%, 3 years 9.6%, yield 2.6%

Those who expect more rate rises to be on the cards need to be very selective about their bond fund choice. When rates rise, bond prices fall; but this fund, due to the types of bond it invests in, will in theory make money if rates rise. ‘It is one of the few bond funds to benefit directly from rising interest rates,’ notes Dennehy.

L&G Global Inflation Linked Bond (tactical pick)

TR 1 year 2.2%, 3 years 4.1%, yield 1.4%

Another bond fund making a return appearance. Last year Mick Gilligan observed that the fund ‘offers an attractive hedge against higher global inflation’, due to the types of bond it backs. For 2018, he is sticking with his choice; it has an OCF of 0.27 per cent.

MI Miton Cautious Monthly Income (income and growth)

TR 1 year 10.8%, 3 years 23.4%, yield 3.7%

Fund manager David Jane has 25 years’ experience as an investor, and Alan Steel says over the years he has successfully shielded capital in volatile market conditions. Steel adds: ‘The fund has been a strong performer over all timeframes. Its risk profile is about half that of global equity markets.’

F&C Multi Manager Navigator Distribution (income and growth)

TR 1 year 7.9%, 3 years 18.8%, yield 4.4%

Rob Burdett’s multi-manager funds represent a solid choice for investors keen to outsource all the decision-making. Managers Burdett and Gary Potter are two of the most experienced fund buyers around. Burdett points out the fund has paid out more income than any fund in its sector since launch 10 years ago, and is top quartile for total returns.

Investec Cautious Managed (tactical pick)

TR 1 year 4.8%, 3 years 18.7%, yield 0.5%

Alan Steel picks this value-focused multi asset fund. Managed by respected investor Alastair Mundy, the portfolio has just over a quarter of its assets in UK equities. Steel adds that it has ‘no exposure to conventional bonds’; Mundy prefers bonds that are indexed to inflation. The fund has returned 7.5 per cent annualised since launch in 1993.

Personal Assets (PNL) (cautious income and growth)

SPTR 1 year 5.7%, 3 years 20.5%, premium 1.2 %, yield 1.4%

Manager Sebastian Lyon and the board of Personal Assets have been crying wolf for years. As a consequence less than half PNL’s assets have been in equities. Shareholders have therefore missed out on much of the bull market. Peter Hewitt expects Personal Assets to hold up comparatively well if there is a substantial pull back in markets.

Aberdeen Diversified Income & Growth (ADIG) (cautious income and growth)

SPTR 1 year 16.7%, 3 years -0.6%, discount -6 %, yield 4.4%

Aberdeen’s respected multi-asset team has managed ADIG since February 2017. It now invests in a variety of non-equity sectors including infrastructure, catastrophe insurance, alternative credit and emerging market debt. Charles Murphy says it is ‘a solid diversifying asset, yielding over 4 per cent’.

Keep up to date with all the latest financial news and investment tips by signing up to our newsletter. Email subscribers will also receive a free print copy of Money Observer magazine.