Could 2023 be the year of the bond fund?

An allocation to bonds is an important part of a diversified portfolio and helps to reduce the overall level of risk. Now that prices have fallen they actually offer a decent yield and the negative correlation with equities looks like it may have been restored.

Ryan Hughes, head of active portfolios at AJ Bell, says that for the first time in a number of years bonds look to be a viable asset class again, given that yields have moved out sharply.

“It now feels like investors are being suitably compensated for the risk being taken and they are providing a genuine alternative to simply holding cash. When building a balanced portfolio, the fixed interest component now looks to be providing a contribution to the total return rather than simply being held for diversification purposes.”

The fall in valuations has left the bond market priced more realistically for the higher inflation and interest rate environment. As long as rates don’t go above something in the region of five percent then bonds look good value over the short to medium term.

Rob Morgan, spokesperson and chief analyst at Charles Stanley, says that yields on corporate credit have soared from 1.6% at the end of 2021 to around five percent today.

“Riskier high yield bonds are once again offering a genuinely high yield, with European and US indices approaching nine percent. Investment grade corporate bonds are paying over five percent in the US and UK. Although investors are facing prolonged inflation and tighter monetary policy, we are now finding areas of opportunity not seen for a very long time.”

The positive returns from these income streams gives bonds more of cushion from further increases in inflation and interest rates, so the balance of risk and reward has improved markedly.

What could possibly go wrong?

Morgan says that the Federal Reserve, Bank of England and European Central Bank all have further to go with their rate hikes.

“They may not start to cut rates in 2023, but the pace of hiking is likely to slow down and with a deep, prolonged global recession looming, we may be nearing the top of the hiking cycle. The sooner this comes the better it will be for bonds.”

If inflation and interest rate expectations subside, bond yields should fall and prices rise. However, a further burst of inflation from whatever source, be it energy, rising wages, or economic strength, would undermine this narrative and make investors think that inflation is going to be stickier and more problematic than widely supposed.

Hughes takes up the theme and warns that uncertainty still persists around where interest rates will settle during 2023.

“In recent weeks there has been an expectation that the rate will be lower than previously thought, but should there be any sense that inflation is not falling back fast enough, I would expect bonds to sell off sharply again. This is certainly a possibility during winter given the uncertainty of the situation in Ukraine.”

Unexpected actions by Vladimir Putin could easily push energy prices sharply upwards again and this would undermine central banks attempts to squeeze inflation lower through tighter interest rates. They have said that they are willing to push rates much higher to control inflation so this has to be the key risk for bonds this year.

If the various central banks raise interest rates substantially more than expected it would obviously be bad news for bonds, but there are limits as to how far they can go. There is so much government, corporate and private debt in the system that economies will not be able to cope if rates are too high.

Mixed Picture

Morgan says that higher quality US, UK and European investment grade corporate bond yields look attractive, as this part of the market should hold up better during an economic downturn and looks cheap relative to historic pricing, especially when considering the strength of balance sheets.

“We see investment grade debt as a valuable portfolio diversifier to weather any recession-driven market volatility. For a more cautious approach, short-dated, high quality corporate bonds could act as a good ballast to portfolios with decent potential to outperform cash.”

McDermott says that he would expect the global downturn to allow the bond market’s performance to improve in 2023 as rates get cut. However, he thinks that credit spreads could widen further, especially if we were to go into a deep recession, which would be particularly bad news for high-yield bonds.

“We feel in risk/reward terms that government bonds are best placed to do well in 2023. We prefer the US to the UK and Europe because the yields are higher and we expect inflation to peak sooner in America. We really like US Treasury Inflation Protected Securities (TIPS) as you can get real returns (a yield after inflation) of almost two percent, which seems pretty good in the current environment.”

He also thinks that corporate bonds are starting to look interesting and believes that they are a good long-term buy, but warns that yields have further to widen and investors may want to wait for real signs of stress before they add aggressively.

The area most at risk is high yield debt, particularly if the recession is longer and more brutal than people are currently predicting, as default rates could rise more than expected. However, the yields are very high, which provides a cushion and the area could be a tactical alternative to parts of the equity universe that delivers similar returns to shares, but with a bit less downside risk and lower volatility.

Core bond funds

Morgan says that for a well-rounded, core global corporate bond exposure, an option worth considering is the Vanguard Global Credit Bond Fund, which seeks to provide a moderate and sustainable level of income by investing in a diversified portfolio of global corporate bonds.

“Its focus is predominantly on developed market investment grade bonds, but with some scope to buy high yield, investment grade emerging market bonds and other asset classes. The historically high income yield of around five percent could provide investors with a solid income return with the added potential kicker of some capital growth if interest rates peak and subside.”

He goes on to explain that investors’ fixed income exposure is often dominated by UK corporate bond funds, but the global approach taken by this product provides a much greater opportunity set, as the UK is only around five percent of the global fixed income market.

There are around 21,000 investment grade bonds in its investible universe and it holds around 1,200 of them.

McDermott prefers Nomura Global Dynamic Bond, an unconstrained strategic bond fund with a focus on total returns. It covers the entire range of fixed income sectors including: government bonds, corporate debt, emerging market bonds and inflation-linked securities.

“The manager studies the state of the global economy and identifies which sectors and investment themes look most attractive. He then undertakes fundamental analysis to populate his preferred areas with ideas,” he says.

Alternatively Hughes suggests Allianz Strategic Bond, which focuses on the government bond market and is managed to bring diversification to other bond funds and equities, therefore playing a useful role in a portfolio.

“While government bonds may not be the most exciting area, manager Mike Riddell can invest across all the government bond markets and uses this flexibility extensively when appropriate. Although its recent performance has been challenged due to the manager’s bearish stance on the global economy, the fund can play a useful role in a portfolio needing diversification in this area.”

Another option suggested by Ben Yearsley, a director at Shore Financial Planning, is the Premier Miton Corporate Bond Monthly Income fund, which is focused on higher than average credit quality and downside protection. It has a high distribution yield of four percent with income paid every month.

Flexible mandates

For a go anywhere type of product Morgan suggests the Janus Henderson Strategic Bond Fund, which is a more flexible fund that invests right across the fixed income spectrum from government bonds to riskier high yield debt.

“Managers John Pattullo and Jenna Barnard aim to add value by taking strategic asset allocation decisions between countries, asset classes, sectors and credit ratings. The fund has recently been significantly invested in longer dated, high quality and more interest sensitive bonds, which was challenging for much of 2022, but would benefit from global inflation subsiding faster than widely anticipated,” he says.

McDermott recommends the Aegon Strategic Bond fund, which he says has a broad and flexible remit and is a true strategic bond fund that can change its positioning very quickly when necessary. He also likes M&G Optimal Income, the flagship offering of the biggest name in the UK bond space.

“This go anywhere fund has a flexible mandate, which enables the manager to shift the interest rate exposure and to invest across the fixed income spectrum. The fund also often invests in certain equities and derivatives.”

Alternatively there is AXA Global Strategic Bond that Yearsley describes as a go anywhere fund that will range from US government bonds to emerging market debt. This currently holds 220 securities from 157 different issuers and pays quarterly distributions.

Corporate Bonds

Hughes likes the Artemis Corporate Bond fund that focuses on investment grade bonds. He says that Stephen Snowden, the manager, has an excellent long-term track record and is prepared to investment differently to the benchmark, making good use of both duration and credit selection to generate returns. It is a high conviction fund that offers good potential for both income and growth seekers.

For those with a higher level of risk tolerance he suggests Invesco High Yield, a core high yield fund managed by the experienced Thomas Moore who has access to a well-resourced team to support him.

“The fund invests across the UK, Europe and the US with all positions hedged back to GBP and is well diversified, investing across more than 100 positions. Income is paid quarterly with a yield of approaching seven percent.”

Yearsley suggests Ninety One Global Total Return Credit, a corporate bond fund that looks at all the opportunities in the corporate world. It seeks to have a balance of shorter term opportunities and more stable companies.

A notable opportunity has arisen in shorter duration bonds with less than five years until redemption. These usually come with a lower yield, but that’s not the case at present and various technical factors, as well as the ongoing hump in inflation and interest rates have presented investors with an unusually high income and redemption yield.

“AXA Sterling Credit Short Duration Bond is one option that could provide a good defensive holding for a portfolio with the potential to outperform cash. A large percentage of the portfolio matures each year and as many bonds trade below ‘par’ there is the potential for a combination of income and modest capital returns. The fund is well placed to capture this opportunity with a diligent and disciplined team building a diverse portfolio,” says Morgan.

Inflation-Linked Bonds

Inflation-linked bonds help to protect investors from negative inflationary effects by linking the bond’s principal and interest payments to inflation measures such as the Retail Price Index (RPI). The trouble is, they also tend to be long duration, so they’ve been hit really hard this year by rising interest rates, although they are now looking more interesting.

McDermott says that their view is that short-term inflation pressures are likely to dissipate, which would reduce the pressure on central banks to keep real yields high and provide healthy capital returns for inflation-linked bonds.

“Inflation expectations remain low, meaning that the cost of inflation protection in inflation-linked bonds is very cheap. So, if inflation surprises to the upside, they should also now offer protection in a way that they did not in 2022. That is why we think they are a good investment at the moment.”

He suggests that an option worth considering would be the iShares Global Inflation-Linked Bond Index Fund. He also particularly likes the hedged version of iShares $ TIPS as it offers the same positive real yield risk-free from a credit perspective.

Morgan says that somewhat ironically, inflation-linked gilts and treasuries tend to be a poor inflation hedge, particularly the longer dated issues that dominate the market, because of the cash flow profile of the bonds.

“For UK linkers and US TIPS, the notional amount is linked to inflation, while the coupon is fixed and typically quite low. As a result, most of the investor’s inflation uplift and return comes from the final principal payment, which means the cash flow profile is very back ended, thereby increasing the duration risk.”

Despite this he thinks that short-dated linkers and TIPS (of up to five years) look quite attractive, as over this horizon inflation could easily average out higher than market break-evens, so there is a reasonable hedge available at current prices.

In order to take advantage he suggests investing in individual short dated index linked securities or a fund such as iShares $ TIPS 0-5 UCITS ETF GBP Hedged. As it is currency hedged, the FX movements won’t overwhelm the return profile.