Ahead of an interest rate rise: how to safely invest in bond funds

Fixed-income investors have a problem. In a climate of rising interest rates and inflation, the normal response would be to turn to those bonds that are less sensitive to interest rate movements: that means areas such as high-yield, shorter-dated or inflation-linked bonds. The difficulty is that everyone will have had the same idea, so prices will be high.

While interest rate rises may seem some way off in the UK – Bank of England governor Mark Carney continues to remind us that the UK economy faces some difficult challenges – the global direction of travel is clear. The US Federal Reserve is already raising rates and Europe looks set to pare back its quantitative easing programme. Inflationary pressures are emerging, albeit with no great urgency for the time being.

This is a tougher environment for bonds in general. In most cases, the coupon on a bond is fixed, so it is less valuable if inflation and interest rates are rising. However, this is a more serious problem for certain types of bond – in particular those that have a long time to maturity, and therefore have more sensitivity to interest rates, as well as those with a low coupon that offers less protection against inflation. If interest rates were to rise very quickly (if inflation looked set to take hold), the situation for long-dated, low-coupon bonds would become even more difficult.

In practice it means much of the UK gilt sector is likely to struggle in the this environment. It also means high-quality corporate bonds, which tend to have low coupons, will suffer. Global government bonds from the US or Europe could face similar problems.

Rate rise risk

Risk has been heightened recently by the fact that longer-dated bond yields have fallen relative to shorter-dated bonds. This is because investors don’t believe the global economy can withstand interest rate rises, and are expecting policymakers to drop rates again in several years’ time.

David Jane, head of multi-asset investment at Miton, says investors are simply not getting paid enough to take ‘duration risk’ – that is, invest in longer-dated bonds that have more exposure to varying interest rates. He adds: ‘We don’t want that in our portfolio. In our bond portfolio, we are in short-dated credit. By the time any recession comes along, these bonds will have matured.

Jane believes some of the diversification advantages that this type of bond used to offer have been overstated. He points out that the correlation between equities and bonds has increased and that there is no reason why they couldn’t go down at the same time, just as they have risen at the same time.

If those are the areas to avoid, which investments offer better prospects? Victoria Hasler, head of research at investment consultancy Square Mile, suggests those bonds where the return is not linked to interest rates.

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She says: ‘In high yield, the risk is linked to whether a company is likely to default on its bonds, for example. Interest rates and inflation are usually linked and investors can expect bonds with a floating-rate coupon (a coupon linked to interest rates) to do better. These may be asset-backed securities or floating-rate notes. Loans should do better as well.’

However, Tom Beckett, chief investment officer at Psigma, points out a few problems with some of these assets. ‘We have pared back our high-yield exposure recently. It has been resilient following the pick-up in the oil price (a lot of US high-yield names are in the oil sector), but now it yields just 5 per cent on average, having yielded 10 per cent in February of last year.’ He says that while Psigma doesn’t see significant risk of a sell-off in the sector as a result of, say, a rise in defaults, it doesn’t see great value either.

Complex picture

Hasler agrees that things are not quite as they seem. For example, in a world where inflation is rising, investors could reasonably expect inflation-linked bonds to do well. However, these come with very high interest rate risk, and that tends to govern the price. As she points out, investors may get inflation-linked returns in the long term, but in the short term they face great volatility. And there is another problem: because lots of people expect inflation to rise, that is already reflected in the high price of inflation-linked bonds.

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Hasler says: ‘It is all a lot more interesting in today’s environment, and there are reasons why the normal approach may not work. The idea that interest rates must go up at the bottom of the cycle is logical, of course, but there is nothing to say that this is going to happen any time soon. In the UK, they could remain at the current level for years.

‘There is also an odd position regarding inflation in the UK to consider. It has been imported through a fall in sterling. While at this point in the cycle, you would expect inflation to rise, once the currency effects fall out, inflation might drop. So rather than inflation and interest rates rising together, as you might expect, this relationship could break down. It’s not our view, but it is feasible.’

So far, so complicated. Given the myriad uncertainties and the expense of fixed income, investors might question whether it is worth holding it at all. However, Gavin Haynes, head of investment at Whitechurch Securities, says fixed interest still has a part to play in investors’ portfolios. He believes it should still work as a diversifier, even if it has correlated with the stock market recently. It also yields income significantly better than cash can produce.

Tricky call

That said, Haynes adds: ‘There is an issue about where investors seek that value. To invest in fixed interest, investors need to make a call on the extent to which interest rates will rise, the degree to which we will see inflation continue to emerge (or start to peter out). When rising commodity prices or weakening sterling start to fall out of the inflation figures, inflation might start to soften, and this would reduce the pressure on the Bank of England to raise rates.

‘However, investors can get too obsessed by short-term movements – a quarter here, a quarter there. In terms of the bigger picture, there is a change in tone from central bankers, certainly, but underlying it is still a “lower for longer” scenario. In the US, there are few inflationary pressures, so it is difficult for the US Federal Reserve to justify raising rates continuously.’

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Haynes is all for leaving it to the experts. He believes it is important to engage a flexible manager who can access different areas of the fixed-income market. He says: ‘People are still rewarded in certain areas of the corporate bond market: a bit each of investment-grade, high-yield and financial bonds.’ He likes short-term, high-yield bonds with less interest rate sensitivity. He takes his core exposure through strategic bond managers –notably using funds such as the Henderson Strategic Bond and Jupiter Strategic Bond funds.

Hasler believes investors should look for a fund manager with strong credit analysis skills. She says that a lot of corporate bonds are overvalued and that investors with strong analysis who can avoid the weaker areas should be rewarded. She adds: ‘We look for people who can do things differently. This could be TwentyFour Asset Management, which takes exposure to asset-backed securities; or companies that are launching different types of fund, for instance M&G’s Floating Rate High Yield fund; or those focused on short-dated assets, such as the Axa Global Short-Dated Bondfund.’

She believes funds such as the M&G Inflation-Linked Corporate Bondfund are also good options in this environment. These hold shorter-dated bonds, and the price is more dependent on the fate of the underlying company. She also suggest managers with an absolute return mindset, where returns may not be the best but capital is protected. The JPM Strategic Bond fund is one such manager.

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Investors have made a lot of money in bonds in recent years, but returns will be harder won from here on. Picking the right types of bonds and avoiding overpriced areas will become increasingly important skills.

While interest rate rises remain slow and steady, and inflationary pressures contained, there is still a place for bonds in a portfolio. If that changes, investors may need to reconsider their positions.

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