Using bond funds to help fight the impact of inflation

Inflation is usually a dirty word in the world of bonds, but now it’s here and hopefully at least peaked, can bond funds help counter its effects?

Soaring prices in the wake of Covid-19 have made life financially challenging for millions of people over the past year. It’s not only pushed up the cost of everything from energy prices to the weekly shop but made the value of basic savings accounts questionable.

Because even though interest rates have been hiked by the Bank of England – and, subsequently, some of those offered by banks and building societies – they’re nowhere near as high as inflation.

Here we take a look at the issue and examine whether funds investing in fixed income can play a part in helping mitigate the problems.

What’s happened?

Soaring inflation has been causing a lot of problems. It rose by 10.1%* in the 12 months to March 2023, according to the Consumer Prices Index (CPI) measure. Although this was slightly less than the 10.4% rate in February*, it’s still more than enough to heap financial strain on spenders and savers.

The harsh reality is that your money will be effectively losing value unless you’re earning a rate of return in excess of inflation. Although the Bank of England has pushed the base rate up to 4.25%, most savings accounts – even the very best - pay substantially less than 4%**. That is a sizeable gap to fill.

Fixed income responses

So, can fixed income products help combat this situation? Are there bonds – and bond funds – that can play a role in countering the impact of inflation?

The answer is yes, although there are issues to consider. The first is whether investing in inflation-linked bonds is the best way to tackle the problem. It may seem an obvious solution, but it depends on the investment horizon, according to an analysis by fund managers at Schroders.

“When held for periods shorter than their time to maturity, returns can be volatile relative to inflation,” they wrote. “This is because the price impact of movements in real yields can sometimes outweigh their inflation-linked income.”

Protecting your portfolio

If you have a shorter investment horizon there are better ways of protecting your portfolio, according to Chris Bowie, a partner in portfolio management at TwentyFour Asset Management. “Floating rate bonds are the best way to combat inflation if you think interest rates will go up in line with inflation,” he said. “That’s certainly what happened last year.”

“The version of bonds that TwentyFour favours are from the asset backed securities market and there are many different flavours of these,” he said. These range from residential mortgage backed securities (RMBS) and then further up the risk ladder into commercial mortgage backed securities (CMBS).

“The benefit of these floating rate bonds is that every three months, the coupon of these bonds resets to the prevailing interest rate plus spread on top,” he added. “However, I wouldn't recommend individual investors buy them as the best way to access them is through funds.”

Be realistic

UK inflation is ridiculously high at the moment, and you need to be realistic about how much can be mitigated, according to Darius McDermott, managing director of Chelsea Financial Services. “It’s almost impossible, without taking undue risk, to get a return or an income of 10%,” he said. “If you get an income return of 5% then you’re halfway to it.”

Darius pointed out that investing in assets that are capable of providing a yield will give some protection against inflation. “There’s a few funds for the higher income end of that spectrum,” he said. “You can actually get somewhere between 5% and 7% in corporate bond funds.”

Fund options

So, which funds in this space may be worth considering? We’ve highlighted a few whose approach to fixed income investing may help counter inflation.

Artemis Target Return Bond 

This fund, which is managed by Stephen Snowden, targets an annual return of at least the Bank of England base rate plus 2.5% after fees. The portfolio invests globally in government and corporate bonds, as well as asset-backed and mortgage backed securities. We think this is an excellent fund for those who want a better return than cash – particularly important in the current environment – but dislike volatility.

M&G Optimal Income 

Veteran manager Richard Woolnough can invest across all of the fixed interest asset classes in this fund, as well as equites, allowing him to express his views on the direction of interest rates and the relative attractiveness of government and corporate bonds without constraints. In rapidly changing environments it can pay to be invested with a manager that has a vast amount of experience. This, coupled with the fund’s flexibility and a current distribution yield of over 4%* makes it an interesting option.

Baillie Gifford High Yield Bond 

This fund provides investors access to a portfolio of mainly UK, US, and European high yield bonds, with a focus on stock picking. The managers – Robert Baltzer, Lucy Isles and Arthur Milson – prefer to invest in companies that can weather economic fluctuations, rather than trying to time markets. The portfolio is well diversified and often contains between 50 and 90 companies. It also has very broad sector exposure.

TwentyFour Absolute Return Credit 

This fund aims to achieve a positive absolute return in any market environment, over three years, and with a modest level of volatility. This is a portfolio that’s easy to understand, with an excellent track record of preserving capital and delivering strong risk-adjusted returns.

TwentyFour remains one of our favourite houses for fixed income and we also like this fund’s low charge.

*Source: Office for National Statistics, March 2023
**Source: Moneyfacts, 24 April 2023

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 manager do not constitute financial advice.