The macro backdrop is bad for bonds, but it would be a mistake to desert the asset class. Kyle Caldwell considers the bond funds best placed to weather the storm.
Rising levels of inflation and increases in interest rates are well recognised as major headwinds that negatively impact bond funds, as both erode the value of the income that bonds pay.
Therefore, given the macro backdrop, with high inflation and rate rises in both the UK and the US, bond funds have recently been under the cosh.
Data from FE Analytics shows that none of the 10 global and UK bond fund sectors have made money since the start of 2022. Funds in the UK Index Linked Gilt sector have fared the worst, down 13.2%.
Over one year, most also posted losses, but over three years, the picture is brighter and most are in positive territory.
Why are bond funds struggling?
Bonds pay a fixed income, which becomes less valuable when inflation rises. At the same time, bonds become less attractive when interest rates rise as there’s greater competition from cash returns and better deals available from newly issued bonds.
As there’s less of an incentive to buy bonds, this results in bond prices falling and yields rising.
To give an example, UK 10-year government bonds had a yield of 0.86% at the start of 2022. That yield has risen sharply, and stood at 1.72% on 12 May.
In response, many investors have been selling bond funds, with almost £6 billion withdrawn in February and March, figures from the Investment Association (IA) show.
Bonds have proven their worth over the long term
Bonds are more complicated and less exciting than equities, but they should not be written off, even in the current challenging environment for the asset class. Over the long term, the diversification benefits of holding bonds alongside equities has helped cushion investors from sharp stock market falls.
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In addition, the income that bonds pay is more reliable than the dividends promised by equities, which can be suspended, cut or cancelled. This, of course, was what happened during the early stages of the Covid-19 pandemic, when scores of companies took an axe to their dividends.
With bonds, the buyer of the bond lends money to a company or government for a fixed period of time. Providing that the institution doesn't go bust, the buyer of the bond is paid interest and receives their capital back at the end of the term.
Bond fund winners and losers as rates rise
When inflation is high and interest rates are moving upwards, long-duration bonds suffer the most. Duration is the sensitivity of a bond, or bond fund, to any change in interest rates.
Long-duration bonds typically have lifespans of 20 to 30 years. Given that investors have to wait a long time for their capital to be returned, a higher level of income is demanded to compensate for the greater levels of risk involved. As a result, this part of the bond market is the most sensitive to increases in interest rates. For every 1% rise in interest rates, a bond’s price will fall by about 1% for every year of duration.
Bonds with a shorter lifespan are less risky since there is less time for things to go wrong and less time for the economic environment to change. Therefore, a lower level of income is typically offered.
Appearing on interactive investor’s Funds Fan podcast earlier this year, Phil Milburn, co-head of Liontrust global fixed income team, said that in a rising rate environment investors should “avoid longer-dated bonds with maturity of 15-plus years”. Milburn added: “The companies themselves will withstand a rate cycle, but bonds are duration-sensitive.”
He also cautioned that most bond indices are long duration. Investors backing UK government index-linked bonds (gilts) have found this out to their cost. While the income payments have risen in line with inflation, the price of the bonds has fallen sharply due to the bonds having a long lifespan, which means they are highly sensitive to interest rate rises.
Tom Becket, chief investment officer at Punter Southall Wealth, says: “With such funds there’s no inflation protection when rates are rising, as the government bonds held have long durations.”
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A way to mitigate risk is to consider bond funds that hold bonds with short lifespans. In other words, those that are a couple of years away from maturity. James Burns, who leads the multi-manager team at Smith & Williamson Investment Management, has previously tipped the AXA US Short Duration High Yield and Liontrust Monthly Income Bond.
Another tactic is to back active managers who have the flexibility to steer their portfolios to the right bond exposures at the right time. Funds in the strategic bond sector can mix and match any type of bond, such as government bonds, investment-grade corporate bonds and high-yield bonds. Other bond funds are more constrained in that they can invest only in a specific part of the bond market.
Metcalfe says: “As well as duration, it is essential to find managers who have demonstrated robust credit analysis. The managers of these teams have shown just that, and in an environment of rising rates globally, it is increasingly important to get both the duration calls and the credit work right.”
Becket is a fan of TwentyFour Dynamic Bond, overseen by a boutique asset manager that specialises only in bonds. He said the fund has built in plenty of inflation protection by keeping bond duration low and investing in ‘floating rate’ bonds, which benefit from every rise in interest rates.
Why the worst of the bond storm may have passed
Becket points out that following the sharp falls in bond prices over the past couple of months, “there are now proper yields for investors to take advantage of”.
He added: “For the first time for a couple of years, bonds are looking attractive, for example, some UK high-quality corporate bonds are yielding 4.5%.”
Rhys Davies, co-manager of the Invesco Monthly Income Plus fund, agrees that there are now more opportunities to make better value purchases in the bond market. The fund, which invests in both bonds and equities, has been making a number of bond purchases recently to take advantage of yields becoming more attractive.
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Davies points out that the yield on the ICE European Currency High Yield Index started the year at 3.4% and is now above 5%, a level last seen during the Covid-19-related weakness in June 2020.
Among recent purchases are Modulaire, a leaser of temporary buildings, (at a yield of 8.3%). Davies also added to existing positions that suffered price falls, such as Gatwick Airport (at a yield of 6.4%), Rolls-Royce (at a yield of 4.9%) and National Grid (yielding 4.9%).
Davies said: “Following years of low interest rates and falling bond yields, we are now seeing higher yields and more volatility in markets. This has provided the opportunity to deliver attractive levels of income for investors as well as the potential for capital growth.”
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