The bond funds the pros are buying as interest rates fall

Although the Bank of England held interest rates steady at 4% following the most recent Monetary Policy Committee (MPC) meeting last month, the path of direction looks clear.

The Bank has cut rates five times since August last year and the mutterings from within is that more will follow if inflation remains persistently high. Indeed, two members of the MPC voted to cut rates to 3.75% at that last meeting.

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Across the pond, the Federal Reserve, facing huge pressure from President Donald Trump, recently cut short-term rates to a target range of 4% to 4.25%.

Analysts expect roughly 75 basis points of cuts in the US by mid-2026 and one to two more 25-basis-point reductions in the UK. The rate-cutting cycle in the eurozone, with rates at 2.15%, is already considered complete.

Bond investors are keeping a keen eye on interest rate policy.

“Falling interest rates make bond investing more attractive,” notes Madhushree Agarwal, portfolio manager on the multi-manager team at Nedgroup Investments. “This is primarily due to the inverse relationship between bond prices and yields - as yields fall, bond prices rise, creating the potential for capital gains in addition to income.”

But there’s more to it than just mechanics. Rate cuts typically occur when central banks are trying to manage downside economic risks - such as softening labour markets or slowing growth.

“In such uncertain environments, having exposure to bonds (also called fixed income) can offer a more stable return profile and help diversify equity risk. Bonds can act as a ballast in portfolios,” explains Agarwal.

Bonds with short lifespans more impacted by interest rate changes

Nick Gait, investment director at Tideway Wealth, however, believes the relationship is even more nuanced.

“Unexpected cuts in interest rates typically provide a short-term boost to fixed-income returns, particularly for funds invested at the shorter end of the yield curve where returns are more closely linked to policy rates,” he said.

“Any short-term gains from unexpected rate movements, however, come at a cost: lower yields today mean a reduced forward-looking return profile. This is why bonds were seen as relatively unattractive before 2022, when base rates across developed markets were at historic lows.”

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At the longer end of the yield curve, Gait said bond prices are less influenced by base rate moves and more driven by inflation expectations. Persistent inflation leads investors to demand higher returns to protect their purchasing power over time.

The most important metric to look at is “duration”, which will be shown on a bond fund factsheet. Duration measures the sensitivity of individual bonds to changes in interest rates.

Fiscal credibility in focus for UK bonds

In the UK specifically, fiscal credibility is also in focus, notes Gait. He adds: “Concerns around government spending and weak growth have made investors more cautious, pushing up the compensation they require to hold gilts. Supply-demand post quantitative easing is also more of an issue. There are not necessarily the natural buyers out there.”

Philip Matthews, fund manager at Wise Funds, said that investors need to be aware that bond markets are already pricing in significant monetary easing.

“With short-term expectations for cuts already high, the balance of risks lies in how inflation evolves and whether central banks can credibly maintain policy flexibility,” he said.

“Corporate bonds remain supported by resilient fundamentals. Companies, consumers, and banks are financially healthy, defaults are contained, and earnings have held up well.

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Matthews, however, notes that concerns about sticky inflation and long-term debt sustainability warrant caution, but points out that yields on offer for bonds still point to good total returns in the coming years.

How bond funds are positioning for lower rates

So, in this lower interest rate environment, where are the opportunities for bonds?

The Nedgroup Inv Global Strategic Bond fund invests in investment-grade corporate and government bonds, mainly developed market, and high-yield bonds.

Agarwal notes that the fund is positioning for strong potential in short duration high-yield bonds.  

She notes that the income bonds are offering today provides “a solid foundation for returns that can be further enhanced through capital gains if yields decline”.

“The shorter duration also means reduced volatility and lower sensitivity to interest rate changes - particularly valuable in a year of shifting rate expectations,” he continues.

The Wise Multi-Asset portfolios hold three fixed-income funds currently including the Premier Miton Strategic Monthly Income Bond fund, which focuses on delivering steady monthly income and capital growth through a diversified bond portfolio, mainly investment grade with some high yield.

It also has the Vontobel TwentyFour Strategic Income fund, which is more flexible and unconstrained, investing globally across government, corporate, high yield, and securitised debt and TwentyFour Income Ord (LSE:TFIF).

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Looking specifically at corporates, Phil Milburn, head of rates in the Liontrust Multi-Asset team, said its global high-yield bond fund will continue to buy bonds in companies it likes over the long term. “One UK issuer we see as being both interesting and robust is Center Parcs,” he said. “Its utilisation rates are incredibly high, and we see that continuing.

Milburn also gives the examples of Medical Properties Trust Inc (NYSE:MPW), a US company which owns healthcare facilities. He notes: “It has a coupon of 8.5% and a yield of 7%. It is on a strong road to recovery and solid asset backing behind its bonds.”

Gait points to the Artemis Short-Duration Strategic Bond. He said: “We continue to favour short-duration strategies, where returns are less exposed to inflation surprises. The Artemis fund combines credit exposure at the front of the curve with flexibility to trade rates without taking on excessive duration risk.

“Some regular strategic bond funds have large potential duration ranges, which can be hard to plan around. Short-dated investment grade is the engine of yield for the fund with high conviction credit selection across investment grade and high-quality high yield.”

He said it also actively trades interest rate strategies by taking a view on the 30-year versus the 10-year gilt, UK versus US, or other global bonds and inflation-linked bonds versus a regular government bond.

30-year gilts

What, then, of the future of 30-year gilts?After years of negative inflation-adjusted yields, UK government bonds now offer real returns, which is a sharp contrast to 2021 when both maturities delivered deeply negative real yields.

However, yield curves (difference between yields for short and long-term bonds) have been steepening, reflecting investors’ demand for higher compensation to hold long-dated bonds.

This shift, both in the UK and globally, stems from heightened uncertainty around inflation and monetary policy. The drivers include tariffs and concerns over central bank independence as policymakers contemplate rate cuts before inflation is fully under control.

Investors are clearly feeling nervous. Yield on 30-year government bonds recently hit 5.72%, the highest rate this century.

Last month, auctions of five- and 30-year gilts issued by the Debt Management Office (DMO) last week attracted the lowest number of orders in the last three years.

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Emma Moriarty, portfolio manager at CG Asset Management, which manages Capital Gearing Ord (LSE:CGT), said a clear trend is emerging: “The DMO is mandated to issue debt in a way which minimises financing costs, and more recently their issuance has shifted away from longer-dated gilts and towards shorter maturities. It is a very concrete acknowledgement of bond markets’ deteriorating confidence in the outlook for the UK.”

So, how should investors play gilts?

Matthews notes that political risks further complicate the outlook for government bonds.

He said: “Internal divisions within the Labour Party and pressure for higher public spending imply increased borrowing needs. Potential policy shifts toward higher taxation, nationalisation, and expanded welfare raise concerns that fiscal discipline may weaken. If borrowing rises further, gilt yields could climb as investors demand greater assurance over debt sustainability.”

Overall, however, he believes that the case for fixed-income allocation is stronger than it has been for many years.

“Government bonds now provide positive real returns and act as a stabiliser against equity market volatility, especially at a time when global equity valuations are stretched. Yet, political risk, inflation uncertainty, and the rebuilding of term premia mean that investors should expect continued volatility, particularly at the longer end of yield curves,” he explained.

Thomas Becket, co-chief investment officer at Canaccord Wealth, favours a balance of short-dated and medium-dated government bonds, with the latter having lifespans of seven to 10 years. He adds: “That would give you bang for your buck without having to take the vagaries applicable to 30-year bonds.”

George Fox, investment manager at Jupiter Merlin, said its bond managers “have been capitalising on opportunities in the longer end of government yield curves, particularly in the UK where gilts are offering a healthy positive real yield and the interest rate path is likely to be lower given the slump within which the UK economy finds itself”.