Why bonds are back in business

Things have changed dramatically for investors in the past 18 months, as rising interest rates amid an inflationary backdrop continue to spook markets. Indeed, the UK’s stubbornly high inflation figures means we are now expecting interest rates of almost 6 per cent in the UK – something that anyone under the age of 30 will not have experienced during their working careers.

As a consequence, high growth companies (think of the tech giants like Amazon, Alphabet and Apple) are no longer the “go-to solution” for investors as they were in the days of QE (quantitative easing - when interest rates were low) and, all of a sudden, UK corporate bonds are starting to look a sensible choice to navigate the continued uncertainty in markets.

Investors turn to bonds

Last month, figures from the Investment Association showed fixed Income funds saw inflows of £632 million, while Government bonds was the top selling sector with net retail sales of £658 million*. This is stark change for an asset class that was very much out of favour in recent years, barring a few spikes in interest.

Of particular interest is the Sterling Corporate Bond sector, which has now seen inflows of £2.2bn in the past 10 months*.

For clarity, the yield on a corporate bond fund is made up of two parts – the risk-free rate (i.e. gilts) and the spread (the difference in yield between the corporate bond yield and the risk free rate on government bonds). Spreads are historically attractive on fixed income at their current levels, but not at the levels we saw on the back of the Global Financial Crisis or Covid, when interest rates were at record lows. At the time of writing, the two-year gilt stands at just under 5.2 per cent**, so you should be looking for around 7 per cent from a UK corporate bond (2 per cent above the risk-free rate).

Bagging a bargain

Not only is the income as healthy as you could ask for – but the risk is lower than it used to be. The bond market is full of bonds issued during the QE era, with lower coupons and the strong yields offered today. Artemis Corporate Bond fund manager Stephen Snowden says the average price of a bond in the sterling corporate bond market today is 87p in the pound. Essentially, for every £100 pound claim on a company you are paying £87 on average across the sector***. 

So they are cheap and offering an extremely attractive income. But there are dangers, not least the threat of recession for the UK – particularly as people roll off their existing mortgages onto far more expensive alternatives thanks to rising rates. One million UK mortgage holders could see their disposable income fall by 20 per cent because of rising rates, according to the Institute for Fiscal Studies (IFS)****.

The argument is that you are being rewarded handsomely to take that risk. If we do fall into a deep recession, the government will cut yields but that should boost the capital returns from corporate bonds.

Stephen says estimates indicate inflation will be in region of 3-4 per cent in the next 10 years – that scenario makes corporate bonds incredibly attractive as you get a decent yield now and if those rates go down, bonds will rise, and you should get a capital uplift***.

Why go active?

The final point is there is now greater dispersion of prices in the bond market – making it ripe for active managers to find opportunities. During 2008 you had bank bonds trading at 10-30p in the pound, whereas utility/telecom bonds were being treated like royalty. Bonds were either incredibly cheap or expensive – very few bonds traded at the average level. Then we had QE and sterling investment grade dispersion came in and started to trade at the average level. But this is starting to change in a post QE world. In a nutshell – markets are creating very different prices for bonds.

M&G Corporate Bond fund manager Richard Woolnough says credit valuations can differ quite dramatically between sectors such as real estate and financials, where spreads remain quite wide, and other sectors such as health care and capital goods where spreads are significantly tighter^. 

He says: “As a result, top down asset allocation will remain important, but it is likely that bottom-up security selection will also have an important role to play.  We believe that a global, flexible and selective approach will therefore be key to unlocking returns.”^

With opportunities abound, here are a few UK corporate bond funds to consider.

TwentyFour Corporate Bond 

TwentyFour Corporate Bond fund looks to achieve the highest possible income with the least amount of volatility. To find his holdings, manager Chris Bowie uses a bespoke quant research tool: Observatory System. This is designed to seek out the best risk-adjusted opportunities. The fund will only hold a maximum of 100 stocks at any one time, so that he can let the benefits of good stock selection shine through. 

BlackRock Corporate Bond 

This predominantly investment grade corporate bond fund combines the benefits of an experienced lead decision maker, Ben Edwards, with BlackRock's vast resources. These include specialist fixed income analysts, quantitative risk tools and a huge 24-hour global trading platform. We like this fund's flexible mandate and Ben's track record of consistently exploiting inefficiencies in the fixed income market.

Rathbone Ethical Bond 

This fund invests in quality investment grade bonds looking for a competitive income whilst generating attractive total returns. Ethical exclusions are simple: no mining, arms, gambling, pornography, animal testing, nuclear power, alcohol or tobacco. This rules out about one third of the index. All positions must also have at least one positive environmental, social or corporate governance quality. The fund has had excellent long-term performance and, despite a style headwind, has held up well in unfavourable conditions.

*Source: Investment Association, May 2023
**Source: MarketWatch
***Source: Artemis: Why investment grade bonds remain a compelling option for investors – May 2023
****Institute for Fiscal Studies
^Source: M&G – Investing In A New Dawn

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 do not constitute financial advice.