Royal London Sterling offers extra yield with less interest rate risk

Many investors should have an allocation to fixed interest, but bonds - which were considered lower risk - look expensive and vulnerable to interest rate rises and inflation. For example, yields on government bonds have been steadily falling and their typically long maturities mean that their value will be heavily eroded if inflation keeps rising in the UK and interest rates start to rise.

But Royal London Sterling Extra Yield Bond invests predominantly in short-dated higher-yielding bonds, which have less sensitivity to rising interest rates and inflation, and generate a higher income. More than a third of the bonds the fund holds have a maturity of five years or less and the fund's average duration - the measure of its interest rate risk - is just 5.3 years.

With expectations that the US Federal Reserve could hike rates as early as March, and a UK rate rise likely in the medium term, average duration is one of the most important considerations with a bond fund at the moment. Interest rate rises mean bond and bond fund yields become less attractive compared with what you could get from a newly issued bond, and this is a particular problem for fixed-rate bonds with a long maturity.

Higher-yielding bonds are more likely to be shorter dated and also offer a higher income, making them more appealing in a rising inflation environment. Royal London Sterling Extra Yield Bond has 47.3 per cent of its assets in bonds rated BB or below and 19.9 per cent in BBB-rated bonds.

The fund also has 30.8 per cent of its assets in unrated bonds, which differentiates it from a number of other funds. Rob Morgan, pensions and investments analyst at Charles Stanley Direct, says: "Unrated bonds tend to have a higher yield than the debt of an equivalent rated company - therefore giving the manager a bit of extra return for undertaking specialist research."

The fund also has a quarter of its assets in bonds issued by financial companies, which in the US and UK have been returning to health, and should benefit from rising interest rates.

Royal London Sterling Extra Yield Bond has delivered returns well ahead of the Investment Association (IA) £ Strategic Bond sector average over one, three and five years. It also has an attractive yield of 6.62 per cent - it targets a yield of 1.25 times the UK 15-year gilt index. And it has a very low ongoing charge of 0.41 per cent.

However, higher-yielding bonds are issued by companies considered more likely to default on their debt, meaning they are also higher risk. And if the UK's vote to leave the European Union negatively affects the economy, or President Donald Trump's policies derail US growth, there could be an increase in bond defaults and problems for this fund.

Analysts at broker Hargreaves Lansdown add: "As they are more sensitive to economic growth, high-yield bonds often perform more like shares than investment-grade corporate bonds. Funds focused on this asset could appeal to investors looking for a high level of income from their investment, but who are willing to take on higher risk."

But Royal London Sterling Extra Yield Bond is a strategic bond fund, meaning it doesn't just invest in high-yield bonds and, importantly, has the freedom to allocate across the fixed-income spectrum. This means that it can move into whatever is currently good, and perhaps even more importantly get out of areas that look bad. So it could move away from high-yield bonds if necessary, making it in theory lower risk than a high-yield bond fund.

So if you want higher income potential than you get with corporate bond funds, and lower sensitivity to interest rate rises and inflation, but with less risk than with a high-yield bond fund, Royal London Sterling Extra Yield Bond looks like a good way to achieve this. Buy.

Source: Morningstar as at 8 March 2017, *Royal London Asset Management

Source: Royal London, as at 31 January 2017

Source: Royal London, as at 31 January 2017

Source: Royal London, as at 31 January 2017

Performance (cumulative total returns %)

Source: FE Analytics as at 8.03.17

IC tip rating