By Leonora Walters, 14 December 2010
Bond funds have had a great decade. The average government bond fund made a 63 per cent return between January 2000 and the end of September this year, while the average for a UK All Companies equity fund was 20 per cent - with far greater risk and volatility to boot.
But all good things must come to an end, and a number of concerns surround the fixed income market. Some commentators are concerned about a bond 'bubble', when a rising market gets overheated. The possibility that inflation will rise is also a concern, as is the prospect of sovereign defaults from indebted European countries such as Spain and Portugal, following bail-outs in Greece and Ireland.
"The upside has definitely been eroded after the rally of the last two years," says Curtis Evans, product manager in the fixed income team at Fidelity. "While there is a lot less upside, there is the possibility of downside risk."
If the bubble scenario is a bit pessimistic, it is generally agreed that government bonds (gilts) are not very attractive because they pay a relatively low level of interest relative to inflation, currently 3.2 per cent. Only nine out of the 34 Gilt funds available currently offer a yield of more than 3.2 per cent.
Bright spots
Concerns aside, you still need to have a portion of your portfolio allocated to these for the sake of diversification, especially if you have a lower-risk appetite or are approaching retirement and looking to buy an annuity, when you should largely move out of equities. The good news is that you do not have to allocate to an area making poor returns or that has a shaky outlook - there are various types of bonds and bond funds, some of which still offer the prospect of good returns.
While European government bonds may have an uncertain outlook and UK ones offer poor returns, corporate bonds continue to look attractive into 2011. Many corporate bonds also have less default or downgrade risk than sovereign bonds.
"If there is even a moderate level of stability in 2011, there are decent returns in prospect in 2011,"says Brian Dennehy, managing director of independent financial advisers Dennehy Weller. "Although not the 60 per cent return available over the past 18 months, still returns will still be perfectly respectable versus little or nothing on deposit."
Some investors are looking to high-yield bonds which pay their holders higher rates of interest but are considered more likely to default. "We expect the strongest returns will come from short duration high yield corporate bonds," comment fund managers Distinction Asset Management.
High yield bonds are paying around 6 per cent over and above what you could get on UK government bonds, plus they provide the opportunity for capital growth. Over the past 12 months high-yield bonds have beaten the return on the FTSE All-Share by around 5 per cent.
In addition to the attractive rate of interest, defaults are falling among issuers of these bonds, as companies have strengthened their balance sheets during the recovery, a trend that Adrian Lowcock, senior investment adviser at independent financial advisers Bestinvest, expects to continue.
The yields on these bonds also don't tend to correlate with underlying government bond yields, adds James Foster, manager of the Artemis Strategic Bond Fund.
If inflation rises, because high-yield bonds pay higher interest rates, they have a better chance of staying ahead of this than their lower-yielding counterparts.
But the risk profile of these bonds is also very different to corporate or government bonds, meaning they are not suitable if you have a lower-risk appetite. Defaults could rise again, for example, if there is a double-dip recession or the European debt crisis worsens. Mr Evans believes that the best risk/reward is to be found in high quality defensive bonds, because these could stand up to a number of scenarios in a much tougher economic environment, such as a double-dip recession.
He anticipates mid single digit returns for these. "Potential for credit spreads to narrow would provide adequate compensation for any default risks, as companies are generally in good shape," he says. "There are now more analyst upgrades than downgrades, although we will not see the double digit returns of the last four years."
Strategic approach
What this underscores is the difficulty in choosing the right types of bond funds at the right time. Conducting the necessary analysis on bonds is typically much more complicated than for equities, especially as there are many macro-economic considerations as well.
But a diversified bond portfolio is helpful in the current environment. For this reason strategic bond funds are growing in popularity. These bond funds have the flexibility to invest in many kinds of bonds, rather than having to put 80 per cent of their assets into one kind like other types of bond funds. They can be highly diversified or heavily weighted to one kind of bond, and as well as moving into areas in which they see opportunities, they can move out of areas of perceived risk.
Strategic bond funds have done well this year, returning 7.66 per cent year to date as opposed to 5.35 per cent for corporate bond funds, and 7.24 per cent for high-yield bond funds. Another advantage of switching between bonds within a fund is that this does not incur capital gains tax, as happens when you buy and sell equities.
The ability to allocate to different types of bonds is particularly relevant now that gilts offer virtually no value and investment grade offer limited value, as they can access high-yield bonds without having to allocate the majority of their portfolios to them. "They also have the ability to shorten the duration (extent to which a bond is affected by interest rate movements) of the fund and so protect it from capital loss if yields continue to rise," says Rob Pemberton, investment director at wealth managers HFM Columbus.
However, because strategic bond funds can change their risk profile over a very short time period they are unsuitable for investors with a low-risk appetite. For example, they could have a large proportion of their assets in high-yield bonds.
"You should hold a mixture of different bond funds because some strategic bond funds are really high-yield funds," suggests Mr Dennehy. "Some strategic bond funds have a global remit, while many focus on UK and Europe. You really need to understand what you are buying - look under the bonnet before you invest in one of these."
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