Bond funds: interest rate outlook and how to look under the bonnet

Bond fund managers who have a flexible mandate, such as those in the strategic bond sector, can pivot between different sectors, credit qualities, and interest rate sensitivities to navigate economic uncertainty.

For DIY investors, the flexibility to make adjustments as interest rate expectations evolve can be a meaningful advantage.

• Invest with ii: Top UK Shares | Share Tips & Ideas | Cashback Offers

It is particularly helpful in current markets as conflict in the Middle East is making the trajectory of interest rates less predictable. 

Before the conflict, the market was expecting two interest rate cuts in the UK and US but as of mid-April, the markets were pricing in one or two rate hikes this year in the UK and no change in the US. 

Is the next move for interest rates upwards?

Bond managers are sanguine, however, and typically believe that central banks will be hard-pushed to implement the multiple rate hikes now priced in, so many are currently favouring short duration. As a reminder, duration is a bond’s level of sensitivity to moves in interest rates.

Michael Siviter, a senior fixed-income portfolio manager at Invesco, sees the recent sharp rise in yields on shorter-dated government bonds in the UK and eurozone as an opportunity for investors.

On interest rates, he notes: “Growth was already weak in these markets, and in the UK, interest rates were already in restrictive territory.”

Aberdeen’s base case is also that interest rates are unlikely to move much higher from here. “Markets have already repriced sharply since late February, with yields rising aggressively throughout March,” says Luke Hickmore, manager of the abrdn Strategic Bond I Acc (BWK27Z3) fund.

While shorter-dated bond yields have risen to reflect the prospect of central banks increasing interest rates to combat inflation, by contrast credit spreads (the difference in yield between safe and riskier bonds of a similar lifespan) have remained relatively range-bound.

This suggests markets have focused on the inflationary implications of the crisis, and could be underestimating the second-round effects on growth, risk sentiment and financial conditions.

This inertia in credit spreads matters because many strategic bond funds have huge weightings to corporate bonds and may suffer if economic growth is stifled by any further escalation in the Middle East.

• Bond Watch: main takeaways from the four key interest rate votes
• Pensions and IHT: the countdown to new tax rules has started

However, fund managers have the flexibility to cherry-pick the best opportunities among corporate credit to withstand either a growth or an inflation shock and still clock a reasonable total return even in an adverse scenario.

“Markets have been struggling to retain a focus in the past six weeks (to mid-April), with trading inflation scares one day versus growth fears the next,” says Alex Pelteshki, co-manager of Aegon Strategic Bond GBP B Acc (B3ZLQW2) fund. “This has introduced an incredible amount of volatility for interest rate risk, understandably, as the asset class is struggling to price both risks at the same time versus central bank policy mandates.”

“As such, focusing even deeper on credit risk, as opposed to trying to guess the moves in interest rate risk, makes a lot of sense to us. While credit spreads are not immune to volatility, they have moved a fair bit wider versus the all-time tights earlier in the year.

“Moreover, the yield in both investment grade as well as high yield means investors are still very likely to notch positive total returns on a 12-month horizon even if the outlook for credit spreads deteriorates. 

“As an illustration, given the relatively short duration of the asset class, the high-yield market needs to see yields increase by more than 300 basis points to start losing money on a one-year horizon.”

Are strategic bond funds using their flexibility?

Mike Riddell, portfolio manager of Fidelity Strategic Bond W Acc (BCRWZS5), argues that some strategic bond funds are not as flexible as others.

As ever, investors should do their homework and get to grips with the investment strategy and then take a view on whether the full remit is being utilised.

At any rate, the difference between one flexible bond fund and another is how active and effective the manager is at shaping its duration and how it is achieving diversification.

He argues: “The Strategic Bond peer group is really a corporate bond peer group, where the average fund typically sits between investment grade and high-yield credit. We can show this by looking at the return of the average fund in the peer group, where we have managed to model it with a simple 60% allocation to an investment-grade corporate bond exchange-traded fund (ETF), and a 40% allocation to a high-yield corporate bond ETF.”

• My 10-point checklist for picking smaller company shares
• Three corporate bonds make first move to appeal to DIY investors

An additional point, raised by Ian Rees, head of multi-manager funds at Premier Miton, is the overall lack of exposure to specialist areas of the bond market – particularly asset-backed securities – which offer high yields and due to their typical “floating rate” nature, would see their income rise in the event that interest rates rise.

“We don’t have much exposure to strategic bond funds because we see a whole breadth of opportunities in alternative bonds and that is something these funds have been making moves towards, but they are limited in the exposure they can take.

“Asset-backed securities are interesting because they have low to no duration, being floating rate in nature.”

However, due to strategic bond funds only having small allocations to this bond type, Rees says he would instead buy a fund that specifically specialises in this area.

An example of a fund that invests in asset-backed securities is TwentyFour Income Ord (LSE:TFIF). Fund firm TwentyFour is a bonds specialist, with all its funds and investment trusts investing in the asset class.  

Emerging market debt

An area of the bond market some fund managers have been turning greater focus towards is emerging market debt.

Joe Sullivan-Bissett, an investment director at M&G Investments, notes that bonds issued by the governments and companies in less mature economies is becoming more of a “structural” position rather than a “tactical allocation”.

• Bond Boss: myth vs market reality for this high-yielding area
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

He adds: “Fundamentals have improved across much of the emerging market universe. Fiscal discipline has strengthened, real yields remain attractive, and around half the market is now investment grade.

“These characteristics are supported by favourable demographic trends and, in many cases, stronger medium‑term growth prospects than developed economies. More recently, heightened geopolitical tensions have increased dispersion and risk premia, which, while uncomfortable in the short term, can create attractive opportunities.”

Managers have been favouring resource-rich nations such as South Africa and Mexico, and countries benefiting from the longer term prospect of a weaker dollar.

However, Invesco’s Siviter cautions that the inflationary and growth implications of higher oil prices are far from uniform across emerging markets.

He sees opportunities in Mexico and Brazil, noting that both central banks “had already adopted a dovish bias ahead of the recent shock and where government measures have helped limit the inflation pass through from higher fuel prices so far, leaving room for further easing”.