The Big Theme
With an uncertain outlook for markets not helped by Britain plunging back into recession you may understandably be drawn to less risky assets, such as cash and safe haven bonds. However, low interest rates and inflation on the rise again mean cash won't generate a real return, while safe haven government bond yields at near or at historical lows only produce a low income.
Willem Sels, head of investment strategy at HSBC Private Bank, suggests these alternatives to pick up yield:
■ extending the duration of any cash deposit.
■ very short dated European sovereign debt, short-dated senior bank debt in the Eurozone, and medium-dated non-financial investment grade (IG) bonds.
■ emerging market debt and high yield.
Locking up your cash for a period is a good way to pick up extra yield if you don't need instant access. Cash is also useful in that an allocation to it reduces risk in your overall portfolio. If you are a very low risk investor or have a short time horizon, for example, are only a year or two away from buying an annuity or cashing in a deposit to buy a house, you cannot risk eroding your gains. Holding cash can be a good short-term strategy if you are uncertain, and want to wait till you see a good opportunity before you deploy it.
"Savers who are not prepared to take risks with their money should still hold cash," says Martin Bamford, managing director of chartered financial planners Informed Choice. "They need to shop around to secure the most competitive rates, ideally not fixing any returns for longer than a year, in case interest rates start to rise. They should also look for tax efficiency where possible, using their cash individualsavings account (Isa) allowances each tax year, in order to keep pace with price inflation."
You can find better rates by shopping around using best buy tables on websites such as Moneyfacts.co.uk.
If you cannot lock up your cash even for a year and are a very low risk investor, you should still not look to riskier assets as inflation erosion has less of an effect over short time periods, and is likely to lose you far less than a sharp downward movement in equity or bond markets. Establishing your risk appetite is very important. "We expect a high level of volatility to continue so investors need to be mentally prepared and to carefully consider their risk/reward profile and tolerance of capital loss," says Robert Pemberton, investment director at wealth manager HFM Columbus.
If you have a time horizon longer than a year or two and a higher risk appetite you could consider corporate bonds. The problem is that private investors can only access a handful of these directly.
Many do not want to invest directly, preferring an instantly diversified investment in a corporate bond fund. Here, because of the changing and dynamic economic situation many advisers such as Mr Pemberton favour strategic bond funds. These invest across the whole fixed income universe rather than being limited to a single area and they can rebalance whenever necessary. This also gives strategic bond funds the ability to outpace inflation, although not all do.
Mr Pemberton recommends JPM Strategic Bond which is run by one of the best bond management teams and is relatively less volatile than the average strategic bond fund (read our tip). He also likes Fidelity Strategic Bond because it has lower volatility than other similar funds because it is run via a cautious approach with no single bond holding dominating returns (read our profile). Jupiter Strategic Bond, meanwhile, is favoured by both Mr Pemberton and Mark Dampier, head of reasearch at Hargreaves Lansdown (see the fund profile).
However, check the fund's mandate carefully as some are higher risk than others, and because of their flexible mandate what seems to be a cautious fund at time of purchase can have a very different portfolio and risk profile in the space of a few months. These are not a substitute for cash or a portfolio entirely focused on government bonds.
Sterling Strategic Bond funds
Source: Morningstar, Lump, % Chg, Init £100.00, Bid-Bid, GBP, Basic Rt Tx, No Cap
Performance data as at 26 April 2012.
If you can take more risk than cash and government bonds, but are not prepared for the changeability of a strategic bond fund, a well managed corporate bond fund is a good option, such as M&G Corporate Bond, a strong performer (read our tip). M&G Strategic Corporate Bond (this invests mainly in investment grade corporate bonds despite its name) recently won the best bond fund category in Investors Chronicle's first fund awards (see fund profile). You could also consider Invesco Perpetual Corporate Bond, run by Paul Read and Causer, two of the most experienced bond fund managers.
If you are prepared to go up the next step of the risk spectrum, you could consider high yield and emerging markets bonds.
"High yield probably remains the most volatile sector in the fixed income area, although it has been remarkably resilient to sovereign volatility and global concerns," says Mr Sels. "This is because companies have been carefully extending funding, conserved cash and limited investment spending, and hence kept defaults relatively rare. Rating agencies expect the default rate to remain low, ending the year at three per cent. High yield spreads should mainly remain a function of equity volatility and sovereign tail risk rather than default fundamentals."
Options include IC Top 100 Fund Kames High Yield Bond (read our tip). This fund delivers very high total returns so is consistently among the top performers in its sector. It has a flexible investment mandate because its aim is to outperform throughout the economic cycle.
"As investors look to diversify away from the west's problems and look for a yield pickup, we think emerging markets bonds have a place in many portfolios," continues Mr Sels. "We have for some time had a preference for hard currency, generally US dollars, denominated emerging market debt over local currency debt. Inflation pressures are starting to resurface in some emerging market countries, and although this is often linked to commodity or food prices, this may delay any further interest rate cuts that could have supported local currency debt."
Threadneedle Emerging Markets Bond holds assets mostly denominated in US dollars (read our profile), and Schroder ISF Emerging Markets Debt Absolute Return invests more than half of its assets in dollar denominated assets.
iShares has just launched its Morningstar $ Emerging Markets Corporate Bond exchange traded fund (ETF) which buys the bonds it tracks including ones issued by corporations based in Latin America, Eastern Europe, the Middle East, Africa, and Asia ex-Japan. It has a low total expense ratio (TER) of 0.5 per cent.
Read more on emerging markets bonds:
But both these sections of the bond market can incur risk similar to that of equities. If you don't have the risk appetite to invest in one of these types of fund reconsider a strategic bond fund because their asset mix may well include these two categories if they are a good place.
If you are prepared to look to equities, high dividend strategies using quality stocks can help boost the income, and buffer the volatility if the stock selection is defensive. "Of course, the risk profile of this strategy is straying further away from fixed income and high dividend strategies are subject to equity volatility," cautions Mr Sels.
He recommends top performing global equity fund M&G Global Dividend, and Schroder Income Maximiser which boosts its yield by using derivatives such as short dated call options. Threadneedle UK Equity Income delivers strong total returns as well as an inflation beating yield, while Invesco Perpetual Income run by veteran investor Neil Woodford also makes good returns. To diversify your income exposure away from the UK try Newton Asian Income.
For an investment trust try Schroder Oriental Income (read our tip) or Edinburgh Investment Trust, more or less a mirror of Invesco Perpetual Income but with a lower TER.
To link or not to link?
With inflation still relatively high and interest rates at historic lows, inflation protection remains an important consideration. However UK government index linked bonds have been very expensive so many advisers argue against buying these and protecting yourself in other ways. However, Darren Ruane, senior bond strategist at Investec Wealth and Investment argues that although inflation-linked gilts are currently priced close to their most expensive levels ever recorded there are many good reasons to hold these, including:
■ inflation linked bonds are a good insurance diversifier in a balanced portfolio and benefit from reducing real yields, locking in a link to a country's price index for the life of a bond and providing a hedge during stagflation;
■ global central banks are deliberately depressing real yields and encouraging consumer spending to generate economic growth and higher inflation;
■ over the longer term there are many reasons to suggest that inflation could be higher than history has witnessed over the past 15 years; and
■ the recent takeover of the Royal Mail Pension Scheme by the government should lead to the cancellation of £9bn of inflation-linked gilts putting upward pressure on a limited free float market.
As the UK is expensive, Barclays Wealth analysts suggests switching into a global inflation-linked basket. "Holders are likely to benefit from different business cycles, central bank policies and geopolitical risks," they comment.
Fund options include iShares Barclays Capital Global Inflation-Linked Bond, a low cost exchange traded fund (ETF).
There are also a limited number of inflation linked corporate bonds you can access via the M&G UK Inflation Linked Corporate Bond Fund (read our tip).
Robert Pemberton, investment director at wealth manager HFM Columbus, suggests getting exposure to inflation linked bonds via CF Ruffer Total Return Fund and Troy Trojan Fund which have large underlying holdings of these assets.