- With monetary tightening expected to moderate, higher-quality bonds look due a resurgence
- Which funds stand out?
Rising interest rates are a problem for many assets, from tech stocks to infrastructure funds. The pain, however, has been felt especially acutely in the bond space, with the average UK gilt fund losing almost 24 per cent last year and continuing to slide so far in 2023.
The upside of that is higher yields, which look promising from an income perspective while offering more of a margin of safety. Some investors also now see bond funds as a play on the fact that interest rates in major economies are expected to peak. While all bonds and bond funds should benefit from a less aggressive rate cycle, some portfolios are worth highlighting as major beneficiaries.
The winners
Whereas short-duration funds have been a go-to for some investors at a time of higher rates, higher-quality bonds with longer durations to maturity – equivalent to their sensitivity to interest rate changes – should benefit most from a cessation of rate rises. That puts more government and investment-grade corporate bond funds in the frame.
When it comes to government bonds, many investors tend to back passive funds rather than trying to eke out small gains via active management, and one option that features in our Top 50 ETFs list is the Lyxor Core UK Government Bond ETF (GILS), which offers a broad source of exposure to the market, including by duration. Around a third of the portfolio was in bonds with a duration of up to five years (a relatively short period for fixed income) in mid-September, with 16.7 per cent in bonds with a duration of more than 25 years and other allocations across the whole spectrum. That diversification should mean the fund should see fewer of the highs and lows apparent in the long-duration parts of the market.
Still, government bond funds with a medium duration (five to 15 years) and longer duration (above that threshold) should have greater scope to make gains on the back of interest rate rises easing, while also offering better yields. Various options are available: take, for example, the iShares $ Treasury Bond 20+yr ETF (IBTL) and SPDR Bloomberg 15+Year Gilt ETF (GLTL). IBTL recently came with a trailing 12-month yield of 3.4 per cent, compared with 3.3 per cent for GLTL. However, both funds unsurprisingly made enormous losses as rates rose in 2022, illustrating the risks of such an approach.
Investment-grade corporate bonds have a high correlation to government debt, and should show a similar level of sensitivity to interest rate changes, accompanied by slightly higher yields and some additional credit risk. Shore Capital’s Ben Yearsley makes the case for Artemis Corporate Bond (GB00BFZ91W59), which recently yielded around 6 per cent, noting that it should fare well if rates have peaked, while also pointing to the Premier Miton Corporate Bond Monthly Income fund (GB0003895496), which we introduced to this year’s Top 50 Funds list.
Active managers do have scope to pick good companies, but Yearsley argues that “anything with high-quality bonds should do well”. So trackers may be a good option here: take the iShares Core £ Corporate Bond ETF (SLXX), which sits in our Top 50 ETFs list and recently came with a 12-month trailing yield of 4 per cent. A drawback in this case may be exposure to some companies that are slightly weaker and more vulnerable in the face of an economic downturn: around half of the portfolio is in BBB-rated debt, or the lowest rung of investment-grade credit.
Investors can take their own targeted approaches by buying gilts and corporate bonds directly – something that can be done via the major retail platforms, even if it can sometimes be easier to put a platform’s name and the word 'bonds' into a search engine rather than attempting to find the right section on the website yourself. When you do get there, the relevant web pages should display metrics such as the yield on offer, the price and when a bond matures.
Going direct helps investors to bank a yield and lock in a guaranteed return, and provides control over the form of exposure taken. Selling a government bond will not incur capital gains tax even if held outside a tax wrapper, meaning investors may wish to bank their gains in this way. As we’ve previously noted, this can influence your buying strategy: gilts with lower interest payments have been available at lower prices, giving investors a greater chance of profiting when the bond is redeemed. From a tax perspective, this looks more attractive than higher coupons, which are subject to income tax. Buying directly can, however, incur greater risks and complications.
Others might consider cash accounts. But investors lured by the high rates currently available should remember that these can change at any time, whereas the interest payment on a bond is at least locked for those who buy and hold. Some of these yields are much higher than in the past: as Charles Stanley chief analyst Rob Morgan notes, the yield on a 20-year gilt has risen from just 1 per cent in early 2021 to 4.7 per cent now, illustrating the fact that bonds “have gone from being hugely overvalued and underplaying the risk of inflation to realistically priced, and potentially good value if inflation proves less embedded than supposed”.
Going strategic
Government and investment-grade bonds seem like a good option when rates peak, whereas high-yield bonds should benefit less, and could even suffer if economic conditions deteriorate. Strategic bond funds, meanwhile, offer less of a targeted play on yields but still suit investors who want something of a one-stop shop. Those funds that use the flexibility available to them will take markedly different approaches – with some making big calls when it comes to the outlook for inflation, rates peaking and even recession.
The names we highlight in the chart have endured a torrid 18 months or so, but do serve as a play on a world of stabilising or falling interest rates. One punchy option is Allianz Strategic Bond (GB00B06T9362), whose manager Mike Riddell uses various techniques – including taking currency exposures and short positions on bond markets – to express his macro views. The investment team has positioned for a recession and a drop in inflation, noting at the start of this year that they had gone long on duration and been "extremely defensive regarding risk assets". But the fund's disclosure can sometimes be confusing, with its literature (and the figure cited in our chart) suggesting it simply invests predominantly in government bonds.
As the chart also shows, a more "conventional" flexible bond fund betting on economic challenges and a rush to safe-haven assets is Janus Henderson Strategic Bond (GB0007533820), which has both a high exposure to government bonds and a reasonably high level of duration, as well as limited exposure to corporate debt. This fund has suffered notably of late but could benefit from a change of conditions, with the investment managers recently suggesting: "We think a tipping point is in sight as the existing tightening in monetary policy from central banks will begin to bite in due course."
