High-yield bond funds lose steam

Since August 2011, 12-month high-yield bond fund yields have fallen by 2 per cent, from 8.8 per cent a year, to 6.6 per cent a year on 30 July 2014.

Meanwhile, the Financial Conduct Authority (FCA) has issued a warning to investors about the growing risks of investing in corporate bond funds.

Because interest rates could be about to rise, the regulator highlighted concerns about liquidity in the underlying market, saying that fund managers could become unable to sell sufficient quantities of bond holdings to fulfil redemption orders, leaving investors unable to sell fund units, if market conditions become extreme.

Ben Yearsley, head of investment research at Charles Stanley Direct, says the biggest risks are rising interest rates and the effect on capital values of both gilts and investment-grade bonds. "When rates rise, money will probably come out of funds, potentially causing a liquidity issue. Another thing to bear in mind is that if there is a liquidity issue both large and small funds will be affected as there will probably be very few buyers," he warned.

Jason Hollands, head of distribution at Tilney Bestinvest, said: "Bond funds aren't risk-free investments and rising rates will have a knock on effect to bond yields and capital values. However, I doubt equities will be immune either.

"Investors should not panic as markets adjust ahead of events, and markets have already adjusted to some degree over the last year. I've been cautious about bonds for some time, favouring funds with more flexible strategic mandates to adjust both credit risk and interest-rate risk."

He says strategic funds are a sensible way of achieving bond exposure within a diversified portfolio. His recommendations include the Twentyfour Dynamic Bond fund (SMIF), and the M&G Optimal Income fund (ISIN: GB00B1H05601).

Juliet Schooling Latter, research director at Chelsea Financial Services, said: "The trouble is that bonds have had such a good run that expectations need to be adjusted for the future. In the short term it is unlikely that there will be much at all in the way of gains and even possibly some losses.

"But we still like strategic bond funds as the managers have more tools at their disposal to mitigate some of these risks and are not limited to what they can invest in. Of the IC Top 100 Funds, we recommend the Henderson Strategic bond (ISIN: GB0007495293), Jupiter Strategic Bond (ISIN: GB00B4T6SD53) and M&G’s UK Inflation-Linked Corporate Bond (ISIN: GB00B44VX079)."

High-yield bond funds with the highest 12-month yields (to July 2014)