Fixed income fund fears

However, the bull market in bonds may soon be about to come to an end. When the US and the UK begin to raise their base interest rates, it is expected that conventional bonds, such as UK government bonds and corporate bonds, will fall in value, losing investors money.

Investors were awakened to this new reality in 2013, when bond values fell in anticipation of a rate rise, with even UK gilts losing investors money. It is unlikely to be the last time gilts drop in value, although the fall in bond yields (which is matched by a rise in the value of bonds) this year has given investors one last hurrah.

Asset management firms have not been unaware of this change in reality and a number of new fixed income products have been launched in recent years that are designed to withstand rising interest rates, including funds investing in asset-backed securities (ABS), loans and short duration bonds.

The draw of these type of funds comes down to this fear of rising interest rates. Conventional bonds all have an exposure to interest rates, called 'duration'. The higher the duration on the bond, the more exposure the investor has to movements in interest rates. This can be a good thing for returns when rates are going down, but investors are widely expected to lose money in conventional bonds if and when interest rates rise.

Short duration funds clearly have lower exposure to interest rate rises and ABS also have very little exposure to interest rate movements. Meanwhile, many loans are set up to be 'floating rate', which means the coupon paid on the loan actually rises with interest rates.

Jim Wood-Smith, chief investment officer at discretionary manager Hawksmoor Investment Management, says he is "hugely enjoying" investing in fixed income at the moment, due to the challenges involved in generating returns from the asset class and the variety of products now on offer.

He says the obsession with "the bursting of the so-called bond bubble" in recent years has led to "a number of alleged through-the-cycle and cycle-proof products" being launched.

He says: "The extension of the bond product range has allowed us to keep our bond exposure nicely diversified. We have exposure to conventional gilts, high yield, ABS, short-dated high yield and to convertible bonds."

But he warns that investors should remain "open-minded rather than dogmatic" when it comes to the prospects for future interest rate rises.

The bond markets have fluctuated considerably in the past year because the market's assumption of when the US and the UK will raise rates has fluctuated considerably. Weak economic data in recent weeks has even led to a rally in bonds, hurting investors that have invested mainly in short duration bonds or those set up to make money when interest rates rise.

Mr Wood-Smith says: "When central bankers make it clear that they have no idea about the interest rate cycle, portfolios should keep their bets hedged. The extraordinary sharp falls in sovereign yields In October make it very clear that betting all on rate rises is a high risk gamble."

The key for Mr Wood-Smith is to put in the "hard grind analysis" in order to make sure that the firm "fully understand the funds we have been buying". He highlights the "duration" of the fund and its "liquidity-in-emergency" as two key factors to consider.

The liquidity of these new types of fund is one of the main aspects that new investors should be careful of. These alternative fixed income markets are not as large and as liquid as gilt or conventional corporate bond markets. This means that if things start going badly and lots of investors start selling out, you may not be able to get your money back quickly, if at all.

The lack of liquidity was one of the reasons why the Financial Conduct Authority recently stepped in to ban the sale of one type of alternative fixed income asset, contingent convertible (CoCo) bonds, to direct investors. The regulator ruled that the complexity of these bonds meant it was too hard for investors to truly know what they were buying.

But that is not the case for most alternative assets. Short duration funds are very similar to conventional bond funds, except that they have much less exposure to interest rates. This is accomplished either by buying normal bonds and using derivatives to 'hedge' away the duration or by simply buying bonds that mature very soon. The problem for investors is that short duration bonds have a much lower yield than higher duration bonds, so they are not great for people seeking a high income. But they should hold up better if and when interest rates rise.

Asset-backed securities have a chequered reputation because of their role in the financial crisis, when bad loans were packaged up as ABS. But the assets are actually fairly defensive and in the hands of experienced managers the bonds carry little extra risk compared with conventional bonds. Loans are a little more risky, primarily because there is not a huge amount of liquidity in the market, which has meant that they have been excluded from the investments allowed in UK-domiciled Ucits funds.

Ben Yearsley, head of investment research at Charles Stanley Direct, says the benefits of these alternative assets means that investors "should consider them" but he warns that investors should "be wary" and need to fully understand what they have bought.

For those willing to do the leg-work to look into the small print of these new assets, and to fully understand the processes of the funds invested in them, alternative fixed income has a genuine place in the portfolio of anyone who thinks interest rates will rise in the US and UK soon.

But for most investors it might be a better bet to invest in a good strategic bond fund. The managers of these funds have the flexibility to invest in these alternative assets, and many of them do, but only with a small proportion of their assets. So investors get exposure to alternative fixed income, without putting all of their eggs in one basket.

Best fixed income funds

When picking a strategic bond fund, it's hugely important to understand the process of the manager. Many of the funds in the IMA Sterling Strategic Bond sector are not true strategic bond funds that invest all across the spectrum, and many of the best-performers will be there because they invest a large amount in high yield bonds, which have done exceptionally well since the financial crisis.

But one manager who truly goes anywhere, investing in a wide range of assets, is Ariel Bezalel, manager of the Jupiter Strategic Bond (GB00B2RBCS16) fund. Mr Bezalel has made his ability to look at and understand fixed income instruments that others fear to touch a real selling point for his fund and his performance has been very strong since the fund was launched in 2008. He has recently put the fund into a very defensive positioning due to his fears about deflation and slowing global growth.

Another strategic bond fund that has a relatively cautious outlook is the Kames Strategic Bond Fund (GB0033988543), run by David Roberts and Philip Milburn. This cautious approach has meant the fund has not shot the lights out in the past few years of rallying bond markets, but the fund has delivered top-quartile performance in the past 10 years by being consistently strong through the market cycle. The fund has some exposure to alternative assets, such as residential mortgage-backed securities (RMBS), a form of ABS, but the team is very selective in terms of what they buy in these alternative areas, and the price they pay.

But for those investors who want exposure to pure alternative fixed income assets, it is better to look at the investment trust universe, where the managers do not have to worry so much about liquidity due to the trust having a fixed pool of capital.

There are a number of options for investors in the Debt investment trust sector, but the standout performer recently has been the TwentyFour Income Fund (TFIF). Managed on a team-based approach by fixed income specialists TwentyFour Asset Management, the fund invests in a range of different assets, including RMBS, collateralised loan obligations (CLOs) and even leases. The team is widely respected and highly experienced at investing in these niche areas of the market.

Back in the world of open-ended funds, M&G Investments recently launched a new fund for manager James Tomlins that has been especially geared for investors who still want income in a rising rate environment. The M&G Global Floating Rate High Yield Fund (GB00BMP3S923) was only launched in September but it has already attracted more than £100m from investors and has been widely tipped, including by Ben Yearsley from Charles Stanley Direct. The fund invests in high yield bonds that have a floating rate, which means the coupon it pays will rise when interest rates do.

Performance of recommended fixed income funds

Source: FE Analytics, as at 20 October 2014