Interest rate hikes are bad for bonds, but these funds are well placed to protect investors’ capital, writes Sam Benstead.
With the Bank of England expecting inflation to hit 13% early next year in Britain, but independent economists forecasting even higher prices, interest rates look set to keep rising to cool the economy.
Market expectations are for a 4% Bank rate next year, from 1.75% today, in a bid to bring down inflation to the 2% target as soon as possible.
Investors sell bonds when rates go up as they can get a better return from newly issued bonds, making old bonds – with their lower yields – less attractive.
While higher yields, which move inversely to price, are good for bond investors, there is a big risk of capital losses if rates rise further than expected. However, some types of bonds have low “duration”, a measure of sensitivity to interest rates.
We asked expert fund analysts which bond funds can give investors the income they need with minimal capital risk if interest rates shoot up higher than expected.
TwentyFour Absolute Return Credit
One way of limiting interest risk is to buy bonds that are “short duration”, meaning that they are close to maturing. Therefore, such bonds are less impacted by changes to interest rates. The trade-off is that such bonds typically have lower yields than bonds with longer maturities.
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Darius McDermott, managing director at fund analyst FundCalibre, said: “Vontobel TwentyFour Absolute Return Credit is a fixed income fund in the ‘targeted absolute return’ sector. It aims to achieve a positive absolute return in any market environment, with a modest level of volatility, over a period of three years.
“It invests predominantly in investment grade bonds that are due to mature soon, which makes it less sensitive to interest rate changes. It has been designed to be easy to understand and does not 'short' stocks or borrow any money to boost returns.”
The fund yields 4.3% and has around £2.8 billion invested in it.
Man GLG High Yield Opportunities
Another way of safeguarding against rate rises is to buy “high yield” bonds, which offer high income but are riskier as the companies issuing the debt are less financially secure than companies issuing the safest “investment grade” bonds.
McDermott said: “At the other end of the fixed income scale, high yield fund Man GLG High Yield Opportunities is managed by Michael Scott, who is ably supported by a team of internal credit analysts who conduct a rigorous analysis of every potential holding and their ability to meet debt obligations.
“High yield is less sensitive to rate rises but the area could really suffer if high yield spreads (yields compared with safe government bonds) blow out if rate rises drive us into a deep recession.
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“However, the manager does have the ability to short and protect the portfolio, so it’s possible it could defend against such a move.”
The trade-off to high yield is that if the economy takes a turn for the worse, these bonds will be sold first by investors. Therefore the biggest risk is an economic downturn. This fund yields 5.5%.
Jupiter Strategic Bond
Run by Ariel Bezalel and Harry Richards, Jupiter Strategic Bond fund takes a “go anywhere” approach to fixed income and can invest in bonds from lots of markets, including high yield or government bonds.
Recommended by interactive investor's head of funds research Dzmitry Lipski, and a member of the ii Super 60 Investment Ideas, it can act as a core bond fund in a portfolio.
Lipski said: “As we move into an environment of rising interest rates and inflation, investors are concerned that this could cause bond prices to fall and yields to rise. Therefore, now more than ever, investors need to look beyond traditional ‘safe’ bonds and adopt a more flexible approach to address rising interest rates and inflation concerns.”
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He adds that in such an environment strategic bond funds should be good investments, as they have the flexibility to seek the best returns from across global markets and to move their duration exposures and asset allocation significantly.
“Given the fund’s flexibility and focus on downside protection, this makes it a strong core option for investors within a well-diversified portfolio,” Lipksi says.
Royal London Sterling Extra Yield Bond
Another good bond when interest rates are rising, according to Lipski, is the Royal London Sterling Extra Yield Bond fund.
Also featured on the ii Super 60 list, but as an “adventurous” rather than “core” fund pick, the main selling point for this fund is its focus on under-researched, non-rated bonds.
Lipski says: “As this strategy involves higher risk, which is often compensated with higher yields due to the nature of this fixed income area, the yield of the fund currently remains quite attractive at 6%.”
Lipski continues: “The fund is managed by highly experienced manager Eric Holt, who has the support of the industry-leading credit team at Royal London, which has a solid long-term record managing bond portfolios both for retail and institutional clients.”
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