Bonds have long been a core part of investors’ portfolios, serving four key roles: capital preservation, providing an income, protecting against inflation and offering diversification away from equities. But are fixed income investments meeting those goals today?
After a decade or more of ultra-low interest rates in developed markets, finding a decent income has become a challenge. Inflation is higher than it has been for more than 30 years and is proving hard for any investment to keep up with. Not only that, but we’ve seen bonds move in the same direction as equites at points of extreme market stress and most bond funds have lost money this year*.
In fact, the US ten-year bond – the bond that is supposed to be ‘risk-free’ – has delivered a real return of -20% over the past two years**, according to Jasmine Yeo, an investment manager at Ruffer. That’s the worst inflation-adjusted performance since 1981**.
So, if they are no longer fulfilling their purpose, is there any point in holding bonds in your portfolio today? Should investors tear up the rulebook and look at other assets classes to fill these roles instead?
Certainly, with inflation rampant in the UK and US and both central banks looking to raise interest rates this year, the risks are higher for bonds and the returns potentially lower than the past.
Bond yields rise (and so bond prices fall) when inflation is high because the real value of the future income from the bond is eroded. Additionally, if the base rate increases, this will cause the interest rates paid on cash to rise, making the interest rate from bonds less attractive.
And the fact that fixed income funds have experienced more than £2.5bn of net outflows in the first two months of this year*** suggests that investors are voting with their feet.
However, Will McIntosh-Whyte, co-manager of Rathbone Strategic Growth Portfolio, says that bonds still have a place.
"We saw when Russia invaded Ukraine bond prices rose and equity prices fell,” he said in an interview. “If more Covid restrictions were to be introduced, then bond prices would likely rise. That is why there is always a role for bonds in portfolios, even if some of the traditional income characteristics are not there anymore.”
Will says that instead of investing in the government bonds of the UK and US right now, he favours the debt of Canada and Australia. This is because those countries are commodity exporters and so would expect to do well in a world of higher inflation.
He has also looked at emerging markets. This is because many emerging market economies have put interest rates up already, so investors could receive a higher yield, but also potentially a capital gain if those economies cut interest rates during the period prior to the bonds maturing.
Ryan Lightfoot-Aminoff, investment adviser to the VT Chelsea Managed funds, says that there is a strong argument to say that the 30-year run of the bond bull market is over. “However, there are still some opportunities, and a role for bonds to play.”
He says that high yield bonds have something to offer in a rising interest rate environment, “with the higher yield margin already in place, and the usual shorter duration of their rate leaving them less exposed to these rate rises.”
However, these high yield companies are usually more economically exposed (hence the higher yield) and therefore there is a higher risk should the economy run into trouble. You therefore need good active fund managers carefully picking the bonds to hold.
Chelsea Selection favourites are Man GLG High Yield Opportunities and Baillie Gifford High Yield Bond.
Mike Scott runs the Man GLG fund and 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. Mike is very experienced and has an excellent track record in navigating the extra risk in the sector whilst achieving above average returns. He has also expanded his investment flexibility to being able to take short positions and thus potentially benefit from falling prices too.
Baillie Gifford High Yield Bond’s strategy is stock-specific, meaning the managers will look for the right holdings rather than focus on the wider market. Ideas will come from a variety of sources but will have the key feature of resilience whether from the company’s competitive position, financial structure or its management team. These ideas will then be analysed for potential risks which can result in the loss of money, the profile of the company’s debt and current valuation.
The other option could be to invest in a total return fixed income product.
TwentyFour Absolute Return Credit, for example, 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 shortly and is a very solid fund, with an excellent track record of preserving capital and delivering strong risk-adjusted returns.
Artemis Target Return Bond is another ‘steady eddie’, with a heavy emphasis on controlling risk. It targets an annual return of at least the Bank of England Base rate + 2.5% after fees and invests globally in government and corporate bonds as well as asset-backed and mortgage-backed securities.
It could be an excellent option for those who dislike volatility but want a better return than cash.
*Source: FE fundinfo, total returns in sterling, 1 January to 25 April 2022
**Source: Ruffer Investment Management, 7 April 2022
***Investment Association, flows for January and February 2022
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.