UK inflation at a 10-year high and a rise in interest rates may not be the kind of conditions in which bonds spring to mind. But no one should have 100 per cent of their assets in equities and, when allocating the non-equity part of your portfolio, there are reasons why you should consider bond funds before other non-equity investments.
Analysts at research company FundCalibre point out that it is because bonds appear boring that they can be rewarding. Their role in a portfolio is not to outpace equities or other potentially high-returning investments. Rather, bonds can diversify equity investments in your portfolio because when equity markets fall, some types of bonds can fall less.
Harry Richards, co-manager of Jupiter Strategic Bond Fund (GB00BN8T5596), argues that the “less spicy parts of the bond market [serve a useful purpose]. They become very valuable particularly in later life when drawdowns or equity market volatility may not be appropriate, and a need for income in retirement is front of mind.”
Bonds can also be a reliable source of income. Although a fixed coupon (interest payment) does not rise in line with inflation, it is not discretionary so has to be paid at that level each year. This means that it is not subject to cuts or cancellations, unlike dividends which companies are not obliged to pay – as UK investors were reminded of in 2020. Bonds pay their coupon unless they default, something very unlikely to happen if they have a higher credit rating.
High-yield bonds pay a higher level of income as compensation for their higher risk of default, which can stay ahead of inflation. There are also many different types of debt instruments, not all of which are fixed. For example, inflation-linked bonds are structured to keep pace with inflation and floating-rate bonds’ coupons can increase or decrease in line with a benchmark.
“To use bonds as a catch-all phrase is very unfair,” says David Jane, fund manager in the Premier Miton Macro Thematic Multi Asset Team. “[For example, you can get a] day when short-dated bonds are going up and long-dated bonds are going down. Within bonds, you can [usually] find something that will do ok but have to be active. That said, you will have to work a lot harder in the next 10 years to make positive returns and diversify equities with bonds.”
Choosing the right types of bond funds and allocating appropriate amounts to them is arguably more complicated and time-consuming than equity allocation. So a good option can be a strategic bond fund. The teams that run these can invest in various types of bonds and debt, so focus on the types of debt that look like the best options and – importantly – avoid what seem like problem areas. See the IC Top 50 Funds for suggestions on strategic bond funds (IC, 10 September 2021).
However, these types of funds are not necessarily suitable for lower-risk investors because the types of assets they have exposure to can change. So, for example, although when you invest in a strategic bond fund it might have a large allocation to developed market government bonds, six months down the line it might have reduced this and increased its allocation to high-yield bonds.
Although other non-equity investments can diversify portfolios and/or provide income, some of these can be difficult to buy and sell quickly. But bonds – at least mainstream types – tend to be fairly easy for the funds that hold them to trade. Bond funds are also typically quite cheap, with charges well below 1 per cent, while funds focused on esoteric assets can have very high charges.
So if mainstream bond funds can diversify your portfolio, provide you with income or fulfil another need in your portfolio it may not be best to look elsewhere.
But Jane adds that over the past “decade or so when equities were doing well bonds were doing less well, and when equities sold off bonds were rising. [But we are] entering another period of rising inflation [so I] would expect bonds and equities to be correlated. [And] if weaker periods for equities continue to coincide with periods of higher inflation expectations, [alternative] assets have an obvious attraction as diversifiers in preference to bonds.”