Bond funds: a refuge as interest rates fall?

Has your financial adviser reviewed your fixed income allocation yet? If they haven’t, it’s time to raise the topic (and maybe reconsider the fees you’re paying).

Bond funds became more popular during this year’s Isa season. UK investors added significantly to their holdings in March, and wealth managers continue to recommend them.

“It’s not a crime not to enjoy the ups and downs of equity markets,” says Nick Gait, investment director at Tideway Wealth. “Some investors just find it hard to deal with. Now we have real returns again from fixed-income funds, ahead of inflation after fees, and without the rollercoaster ride of equities.”

Granted, you can still get good income via cash savings — the top rate on a one-year fixed-rate savings bond is 5.21 per cent at Habib Bank Zurich. You could also buy the “risk-free rate” by investing in gilts and get more than 4 per cent.

But if you invest in corporate bonds, which are taking a step up the risk ladder, you can get higher income, with more potential for capital gains too. Even investment grade corporate bonds should yield more than gilts, because companies can and do go bust and management teams can do silly things. You can currently get a yield of about 6 per cent from corporate bond funds that invest in the safest type of corporate debt.

Wealth managers as well as fund managers are shouting “opportunity knocks” in this area because, to many, interest rates will soon start to come down — analysts say that with consumer prices index inflation at 2.3 per cent, keeping the UK base rate at 5.25 per cent doesn’t feel sustainable.

Wealth management firm Evelyn Partners has been increasing its asset allocation weighting to fixed income at the expense of some of other non-equity sectors such as alternatives, because of the “compelling” yield opportunity. Edward Park, chief asset management officer, says: “With cash rates likely to reduce in coming months, the fixed-income market offers the opportunity to ‘lock in’ some of the higher interest rates that remain on offer within the bond market.”

Why isn’t the industry doing a better job of signposting and helping customers to navigate fixed income? It remains a confusing landscape for private investors (and some advisers) to traverse

If base rates come down, there could be capital gains too, followed by lower yields further ahead. However, Stephen Snowden, head of fixed income at Artemis Investment Management, says: “Irrespective of your view on base rates, I think the bond market is close to being a win-win. Let’s say base rates don’t come down, because growth is a bit better and inflation remains a touch higher than its 2 per cent target. In that scenario we end up with no capital gains, but just a persistently high yield on corporate bonds (the yield on the index today is above 5.7 per cent) that’s beating inflation.”

In financial planning terms, UK government bonds are a low priority for Isa tax wrappers because all gains within these are exempt from CGT and income levels are relatively low. But in the case of corporate bond funds, Isas are an ideal holding account because of the ability to earn higher levels of tax-free income. And pension investors in retirement would be wise to use fixed income funds as a buffer against equity falls too.

So why isn’t the industry doing a better job of signposting and helping customers to navigate fixed income? It remains a confusing landscape for private investors (and some advisers) to traverse.

The Investment Association divides up the 4,500 funds available to buy into 50 smaller sector groups to allow comparisons on performance and fund charges.

If I tell you that 17 of these 50 sectors are equity sectors, you may think there would be fewer dedicated to fixed income. But you’d be wrong — there are 22. Add to these, the Mixed Asset sectors that have fixed income as a large part of the asset allocation and you get 24 that are focused on bonds.

The fixed income sectors are good at distinguishing by geography — if you want a Global Emerging Markets Bond Fund denominated in local currency, there’s a specific sector for that.

But there’s currently no sector distinction between funds that invest in short-dated bonds and those of a longer duration, whose return characteristics will be very different. And this is what investors new to bonds really need.

Because the principal is due to be repaid sooner, shorter-dated bonds are, in theory, less affected by uncertainty about future interest rates. This should make them less volatile at times of economic uncertainty. Should interest rates come down faster than the market expects, longer-duration funds, which have a higher degree of interest rate sensitivity, will see their capital values rise.

Another navigation problem is active and passive funds sitting together in the same sectors. Advisers say you should generally avoid index tracking bond funds because they tend to have a longer duration, increasing the risk of capital losses. Meanwhile, passive funds targeting a shorter duration of 1-5 years may suffer from elevated trading as they are forced to buy and sell bonds as they constantly fall in or out at either end of the maturity spectrum.

Advisers also warn that the most indebted companies have the largest weightings in the index. Plus bond indices are dominated by financials and utilities companies, meaning your investment is skewed to these sectors in a way it wouldn’t be with an active fund manager who can spread your risk further. Wealth management firm Quilter maintains a bias towards active managers in fixed income because they can select the issuer and issuance, plus look for relative value opportunities in the new issuance market.

Gait says: “Active managers do seem to earn their money. The fee disparity between active and passive is much lower in fixed income. While active equity funds tend to charge 0.75 per cent and passives 0.10 per cent, with bond funds active costs about 0.30 per cent and passive 0.15 per cent.”

Tideway Wealth recommends the Artemis Short Duration Strategic Bond Fund, which spreads investments across government bonds, investment-grade and high-yield bonds, shifting the balance as conditions change. Quilter recommends the TwentyFour Dynamic Bond fund, a flexible bond manager that can shift through the universe including allocations to non-core assets such as asset-backed securities.

If you don’t have an adviser, try looking at an investment platform’s recommended fund lists. When I Iooked at lists at seven platforms during Isa season in March, the five most recommended actively managed bond funds were Artemis Corporate Bond, Jupiter Strategic Bond, M&G Emerging Markets Bond, Royal London Corporate Bond, and M&G Global Macro Bond. There are no guarantees but, with three platform recommendations each, it’s a consensus that provides a little reassurance.

Moira O’Neill is a freelance money and investment writer. She holds Jupiter Strategic Bond fund. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com