Select fixed income for your Isa with caution

Enthusiasm for bonds has cooled over the past few months. Investment Management Association (IMA) figures show that equity funds outsold fixed income in each of the last four months of 2012. "Fixed-income funds attracted most retail money in 2012, the fifth consecutive year in which fixed-income funds outsold equity funds," said Daniel Godfrey, chief executive of the IMA. "However, there was a clear shift in investor behaviour towards the end of 2012."

The great rotation out of bonds into equities is partly due to increased confidence as European debt problems appear less serious than anticipated, encouraging investors to move back into riskier assets.

What's more, some professional investors are concerned about a bond bubble, believing that corporate as well as government bonds are overvalued, while last year the Financial Services Authority (FSA) wrote to fund houses requesting reports on whether their corporate bond funds could meet redemption demands, amid liquidity concerns in the fixed-income market. "The problem for investors is that many corporate and high-yield bonds are fairly illiquid," says Robert Pemberton, investment director at HFM Columbus Asset Management. "If everyone heads for the exit at the same time then bond prices will be heavily marked down and, in the very worst case scenario, funds could be temporarily suspended until enough underlying-holding bond sales are executed to repay redemption requests."

Tom Becket, chief investment officer at PSigma Investment Management, agrees: "Liquidity risks are concentrating our minds most. Firstly, many [bond] funds have grown to extraordinarily large sizes and were these funds to suffer significant outflows they would potentially struggle to unload positions in to illiquid markets, where volumes are at almost unprecedentedly low levels. These funds will be difficult to manoeuvre if there is a shift in sentiment towards corporate bonds. Credit markets used to be supported by investment banks that held an inventory on their books, but they are no longer allowed to by their compliance and risk department. Investors might perceive the three big risks of 2012 (US fiscal cliff, Europe debt crisis and China slowdown) to have eased, which could encourage an equity increase at the expense of fixed interest. We have taken steps to mitigate risk by selling all of our corporate credit funds with duration and bought short duration funds where the time to redemption of all bonds is under 2.5 years."

Mr Becket doesn't believe that typical investment-grade corporate bond funds are compensating investors for the risks they are taking if yields after charges on core funds are only around 3 to 3.5 per cent.

Wealth manager Ashcourt Rowan has also recently moved money out of larger bond funds run by well-regarded managers such as M&G and Invesco Perpetual. "Following the FSA announcement that it is investigating the liquidity within the retail corporate bond sector and the subsequent statement that certain funds were trying to stop the flow of monies into their corporate bond funds, we reviewed all our fixed-income exposures," says David Esfandi, managing director at Ashcourt Rowan. "Our focus was on finding liquid actively managed corporate bond funds."

IC Top 100 Fund M&G Corporate Bond Fund (GB0031285678) is £6bn in size and Invesco Perpetual Corporate Bond (GB0033050690) fund is £5.86bn.

The best bond funds

Advisers do not recommend that you abandon bond funds, but rather be selective in your holdings. "It is never wise to concentrate portfolios too much," says Willem Sels, UK head of investment strategy at HSBC Private Bank. "We like to hold some bonds because no other asset class can completely fulfil the role that bonds play, such as income and diversification. We continue to have a small exposure to many areas of the bond markets for that reason, including government bonds, index-linked gilts, investment-grade, high-yield and emerging market debt. We focus on funds with short duration."

Short-term bonds generally mature in up to three years. Longer-term bonds are considered a higher risk because interest rates are certain to change during their lifetime, but they tend to pay higher interest rates to attract investors and reward them for the additional risk.

Funds offering exposure to shorter-duration bonds include iShares Markit iBoxx £ Corporate Bond 1-5 exchange traded fund (ETF) (IS15) which has a total expense ratio (TER) of 0.2 per cent. The Markit iBoxx £ Corporates 1-5 Index offers exposure to Sterling-denominated corporate bonds with an expected remaining time to maturity of between one and five years. The index includes only investment-grade bonds with a minimum amount outstanding of £100m.

iShares Barclays Euro Corporate Bond 1-5 ETF (SE15) and iShares Barclays Euro Corporate Bond ex-Financials 1-5 ETF (EEX5) also target bonds of these maturities, and have TERs of 0.2 per cent.

"There is little capital risk in short-duration bonds, although obviously the yield from these securities is very low," says Mr Pemberton.

Growing numbers of investors are choosing to hedge their bets by opting for a fund that sits in the IMA's £ Strategic Bond fund sector. The broad definition of the sector allows managers to invest across the sterling fixed-interest credit risk spectrum. In an environment where there is heightened uncertainty about inflation and the direction of interest rates, such flexibility is very attractive. But managers' strategies can differ dramatically so you need to choose your fund carefully.

"Strategic bond funds with a high weighting to high-yield bonds did very well last year, but we feel most of the juice has now been extracted from this sector and instead are increasingly recommending bond funds with a more defensive cash-plus objective and which have a short or even negative duration. Examples are SWIP Absolute Return Bond Fund (GB00B1265859) or JPM Strategic Bond Fund (GB00B3RJ9K34)," says Mr Pemberton.

Read our tip on JPM Strategic Bond

But he continues to recommend Jupiter Strategic Bond (GB00B2RBBC80) (read our tip) and IC Top 100 fund M&G Optimal Income (GB00B1H05049). "We think the managers have the competence to navigate through what are increasingly choppy waters in fixed-income markets. While still recommending these funds, we are only expecting mid-single-digit returns this year, far lower than in the past few years," he says.

If there is a widespread sell-off in bond markets then strategic bond funds will not be immune to it, but Gavin Haynes, managing director at chartered financial planner Whitechurch Securities, continues to favour some of these.

He says: "Overall our position in fixed interest is underweight at present, due to the fact that we see little value in conventional gilts and large part of the corporate bond markets. However, we do see opportunities in fixed interest across the globe, particularly in short-dated high-yield corporate bonds, emerging market bonds and index-linked bond funds."

His favoured funds include Legg Mason Global Multi-Strategy Bond (GB00B2R8FG10), and for inflation protection Standard Life Investments Global Index Linked Bond Fund (GB00B00ZJM99) and IC Top 100 Fund M&G UK Inflation Linked Corporate Bond (GB00B6WVM393).

Ashcourt Rowan reallocated to the JPMorgan Sterling Corporate Bond Fund (GB0030877434) and Kames Investment Grade Bond Fund (GB00B1419R57), which are respectively £216m and £537.47m in size - an important consideration, according to Mr Esfandi. "The size of these funds allows the managers to execute their top down views and take a tactical and nimble approach," he says.

PERFORMANCE OF BOND FUNDS

Source: Morningstar

Notes: Performance figures show total return in % change on an initial £100 lump sum, invested on a bid-bid basis, for a basic rate taxpayer. * 1 January to 1 March 2013.