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Tread carefully with bond funds

Bond funds can offer diversification and income but face a number of risks
August 22, 2019

The high risk, high return nature of equity investing means that stock markets tend to drive the bulk of performance in many portfolios. So investors seeking growth often allocate heavily to equities at the expense of other investments. But this year many investors have reduced their equity exposure even though stock markets have made substantial gains. UK investors, for example, withdrew more than £2bn from equity funds on a net basis in the first half of 2019 and, by contrast, put nearly £6bn into bond funds.

Fixed income investors have been rewarded with strong returns lately, with government bonds performing well late last year while equity markets struggled. They have also generated strong returns this year as investors worry about challenges facing the global economy such as trade wars and slowing growth, and look for a safe place to park their money. “The cyclical slowdown and a wall of political worries have created a surge in demand for safe assets," explains Chris Iggo, chief investment officer for fixed income at AXA Investment Managers. "Investors are trying to figure out what it all means. Will there be a US recession? Will there be a bear market?”

Conditions have also improved for the asset class more generally. Just a year ago central banks appeared set on increasing interest rates and bonds tend to perform badly when rates go up, in part because it makes the yields they offer less attractive. But growth concerns have forced central banks to change tack and the US Federal Reserve made its first rate cut in a decade at the end of July.

Bond funds also play an important role in diversifying portfolios when equities look vulnerable. Higher-quality government and corporate bonds can have negative correlations with equities, meaning that they should perform well when stock markets fall and investors rush to defensive assets. This is what happened in the fourth quarter of 2018: Bloomberg Barclays Multiverse, a broad index of global bonds, was up 3.7 per cent in sterling terms over the quarter while MSCI World, an equity index, fell 11.5 per cent.

High-yield bonds and emerging markets debt, meanwhile, offer high yields which could be of interest to income investors. 

High-yield bond funds have performed strongly in recent years, pushing down yields. But many still offer a good income – most of the biggest funds in the Investment Association (IA) Sterling High Yield sector tend to have a yield of at least 4 per cent, with some such as Invesco High Yield (GB00BJ04GF14) offering a distribution yield of more than 6 per cent. Emerging markets debt funds also offer healthy levels of income.

 

Be aware of bond risks

Diversifying characteristics, strong performance and the yield still available in certain parts of the fixed income market might tempt you to allocate more to bond funds. If you do, consider exactly what you are using certain types of bond funds for and be highly selective about the ones you invest in, because this asset class faces significant challenges.

If you are thinking of allocating to bond funds for diversification, bear in mind that prices of higher-quality bonds have sky rocketed, potentially limiting their future returns and putting them at risk of a fall. Yields, which move inversely to prices, have become negative on many bonds, meaning that investors effectively pay the borrowers to hold their debt.

Investment manager Heartwood notes that bonds with negative yields bonds now amount to a value of $16 trillion (£13.23 trillion), up from $6 trillion in October 2018. This is particularly the case with European government bonds and also some debt issued by companies. So, although higher-quality bonds might offer diversification, you should be under no illusion about their costs.

Glenn Meyer, head of managed funds at RC Brown Investment Management, says: “Yields have collapsed, making bonds very expensive and often guaranteeing a loss if [you hold them] to redemption. [So] we have used bonds to help manage volatility in broadly diversified portfolios that include a wide range of asset classes and geographies – instead of as a source of predictable return.”

There is also no guarantee that bonds will be negatively correlated to equities next time stock markets fall. Ben Conway, an investment manager at Hawksmoor Investment Management, notes that diversifying benefits can “come and go”, with government bonds showing a positive correlation to equity markets this year.

High yield and emerging markets debt, meanwhile, is at greater risk of default. “Searching out high-yield bonds to provide an unrealistically high income expectation seems to me to be a fool’s errand, as the reduction in credit quality needed makes the balance of risk and reward unattractive,” says Mr Meyer.

Emerging markets bonds displayed their volatility earlier this month when the price of Argentina's debt tumbled after Alberto Fernandez, a populist politician, won nationwide primary polls by a bigger margin than expected. This affected funds with a high allocation to this asset such as Templeton Emerging Markets Bond (LU0768360199), which fell 2.27 per cent between 12 and 14 August, in sterling terms. At the end of July, the fund had 10.46 per cent of its assets in Argentina, in contrast to JPMorgan EMBI Global index's 3.53 per cent weighting to that area.

 

Flexible funds for difficult times

Because of these risks, a good way to invest in fixed income can be strategic bond funds. These can invest across the entire bond universe, enabling them to respond to changes in the asset class by adjusting their allocations.

For investors seeking diversification, one fund that currently has a large allocation to government bonds is Allianz Strategic Bond (GB00B06T9362). It had nearly 90 per cent of its assets in government bonds at the end of June, with 31.1 per cent of its assets in debt with a AAA rating – securities considered least likely to default by rating agencies. The fund returned 11.4 per cent in the year to the end of June, placing it ahead of every fund in both the IA Sterling Strategic Bond sector and the IA Gilts sector, whose constituents primarily focus on UK government debt.

Some strategic bond funds invest in a wider spread of bonds but still offer a defensive approach. These include Jupiter Strategic Bond (GB00BN8T5935), whose manager Ariel Bezalel derisked the fund at the start of 2018. It had 44.4 per cent of its assets in government bonds and 47.3 per cent in corporate bonds at the end of July. An Mr Bezalel's defensive approach has paid off: in 2018, when MSCI World, an equity index, fell 3.04 per cent in sterling terms and every asset class registered a loss, Jupiter Strategic Bond fell just 1 per cent. By contrast, the IA Sterling Strategic Bond sector average fell 2.5 per cent.

But some investors believe there are cheaper ways to get defensive exposure. Mr Conway argues that the best strategic bond performers of recent times have simply upped their duration – a fund's sensitivity to interest rate changes – rather than “doing anything magical".

He adds: "If this is the case, the extra tens of basis points investors pay for this diversification over directly investing in government bonds or via an exchange traded fund (ETF) is probably not worth it."

If you just want exposure to government bonds and do not wish to pay the higher charges of strategic bond funds, options include Lyxor FTSE Actuaries UK Gilts UCITS ETF (GILS). This fund, which we include in our IC Top 50 ETFs list, offers broad exposure to UK government bonds of different durations or levels of sensitivity to interest rate changes. It has an ongoing charge of only 0.07 per cent.

David Absolon, investment director at Heartwood, believes that the effect of political uncertainty means UK government debt represents slightly better value for money than other high-quality debt such as German Bunds. “Although low, UK government debt has positive yields, with investors still being paid to take on risk,” he explains.

Although some of the largest strategic bond funds, such as Jupiter Strategic Bond and M&G Optimal Income (GB00B1H05601), have built up big weightings to more defensive assets, a number of others focus on riskier bonds. This means that they can generate a higher income but still have the option of changing tactic if conditions deteriorate. But before investing in such a fund make sure you understand the risks they incur.

One fund with such an allocation that has done well is Royal London Sterling Extra Yield Bond (IE00BJBQC361). The fund focuses on corporate debt, and had more than 70 per cent of its assets in high yield or unrated bonds at the end of June. The fund has a yield of around 5 per cent despite its strong returns, and it has been among the top 10 performers in the IA Sterling Strategic Bond sector in 2015, 2016, 2017 and 2018. The fund has lagged slightly so far this year because of its lack of exposure to government bonds, but had still returned more than 5 per cent by the middle of the year. It has a good level of diversification, with exposure across different sectors and credit quality levels, and had 233 holdings at the end of June.

Active emerging markets debt funds have also done well. But when investing in an emerging markets bond fund a major consideration is its currency exposure. These funds can invest in debt denominated in local currencies, hard established currencies such as the US dollar or a mixture of both. Those invested in local currencies can be volatile and struggle when the US dollar is strong, so a fund focused on hard currency could be a better option. 

[See the big theme of 19 July for more on this]

Mr Conway favours M&G Emerging Markets Bond (GB00B4TL2D89), which yields 5.75 per cent. This had a mixture of corporate and government debt at the end of July, with 67.2 per cent of assets in hard currency. 

Another fund that has performed well but still offers an attractive yield of 5.6 per cent is BNY Mellon Emerging Markets Corporate Debt (IE00B5MQD788). The fund’s holdings are almost entirely US dollar denominated, and nearly half of its assets are in higher-quality, investment grade bonds. The fund’s managers have recently upped their allocation to high-yield bonds because they think that emerging markets companies look stronger than before and could benefit from central bank easing.

 

Fund performance
Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)Ongoing charge*(with HL saving if preferable)
Allianz Strategic Bond15.3112.2226.5687.60.79 
BNY Mellon Emerging Markets Corporate Debt9.19.8525.19 0.77 
Jupiter Strategic Bond8.7113.1822.91105.680.720.54
LYXOR Core FTSE Actuaries UK Gilts UCITS ETF9.82   0.07 
M&G Emerging Markets Bond17.1725.9872.7139.020.75 
Royal London Sterling Extra Yield Bond5.1727.341.49212.660.4 
Bloomberg Barclays Global Aggregate Hedge GBP index8.226.7418.1348.49  
FTSE Actuaries UK Conventional Gilts All Stocks index9.467.1333.0970.94  
IBOXX UK Sterling Non-Gilts All Maturities index8.028.631.2390.22  
IA Global Emerging Markets Bond sector average13.6413.7833.177.63  
IA Sterling Strategic Bond sector average5.939.7819.8872.46  
Source: FE Analytics, *fund providers. Performance data as at 19/08/2019