We believe now is a good time to consider adding certain bonds to your portfolio. In this article we discuss the reasons why and reveal the best bond funds to buy.

Bond markets have been through one of their most challenging times ever after the US Federal Reserve’s pivot towards raising rates caught investors off guard.

Year-to-date the Bloomberg Global Bond Aggregate index is down around 12% and has lost almost 15% from the peak in August 2021, one of the deepest drawdowns since the early 1980s. Don’t let that put you off bonds as an investment.

WHAT’S GONE WRONG?

Bonds have been impacted by a toxic combination of rising inflation and higher interest rates. Inflation reduces the real value of interest payments and bond prices fall as interest rates rise.

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The silver lining is that decent income is now appearing with US 10-year bonds paying more than 3% interest.

The US central bank is fighting inflation by aggressively raising interest rates despite the fact some of the causes of 40-year high inflation are outside its control.

Guggenheim’s chief investment officer Scott Minerd, who oversees over $300 billion of assets, believes the decades-long bull market in bonds is over.

Minerd has warned interest rates could trend higher for a generation which is bad news for bond investors.

That view is not shared by the Federal Reserve. The US central bank wants to move interest rates up to a ‘neutral’ level before deciding if the economy needs something more restrictive.

The bank hasn’t divulged what neutral is, but most economists believe it is between 2.5% and 3%. In theory a neutral rate neither tightens nor stimulates the economy.

KEY RISKS TO CONSIDER

Analysts and forecasters are the most divided about what the future holds in more than a decade, which means it is dangerous to wed yourself to any one particular outcome.

We focus on the two most unappetising scenarios which worry investors; an economy which runs too hot and that leads to persistently high inflation or a full-blown recession.

As we go on to explain, both these scenarios support the argument for increasing exposure to government bonds and high-quality corporate bonds. One caveat is that If Minerd’s view turns out to be correct (high interest rates for a long time), all bets are off.

BOND INVESTORS EXPECT INFLATION TO FALL BACK

The Fed’s preferred measure of core inflation is PCE or the personal consumption expenditures gauge. This hit 40-year highs of 5.13% in February before falling slightly in March.

The forward inflation expectation rate, also referred to as the ‘5y5y’ spread, suggests inflation will fall to 2.4% in five years’ time.

This measure takes the difference in market interest rates in five years’ time, typically the 10-year minus the five-year rate to calculate market implied inflation.

A second measure compares five-year inflation-protected bonds with conventional five-year government bonds.

According to the St. Louis Federal Reserve data, this measure suggests inflation will be around 3% in five years’ time. This is only 1% above the Fed’s medium-term policy target.

This might seem quite surprising given all the hype over the threat of runaway inflation.

The implication is that the market thinks the Fed is making a policy error. In other words, it is raising interest rates in the face of an already slowing economy.

This could accelerate a slowdown or even a cause a recession. Inflationary pressures would then be expected to abate quickly.

Under this scenario interest rates would probably fall, pushing up bond prices, which means investors buying now could expect to see a capital gain in this scenario. Longer-dated bonds would be expected to rise more than shorter-dated bonds.

A contributing factor to the market’s sanguine outlook is recent data which seems to suggest an easing of global supply chain disruptions. These have been a major cause of producer price inflation.

In the past few weeks supplier delivery times have shortened considerably, according to Markit. This data is also supported by a peaking in global container freight rates based on information
from Drewry.

WHAT IF THE BOND MARKET’S SANGUINE VIEW IS WRONG?

Hedge fund Verdad studied the returns of shares, bonds and commodities during periods of rising interest rates and stalling growth. Surprisingly bonds outperformed shares handsomely.

Looking at the period between 1970 and 1982 which for most investors represents the last period of high and persistent inflation, US 10-year government bonds delivered a positive 3% annualised return compared with a negative return of 6% for shares. Commodities did well with oil and gold posting 20% annualised returns.

However, the maximum drawdown for bonds was 19% compared with 43% for shares, 52% for gold and 28% for oil. A drawdown is the percentage fall from peak to trough.

As it turned out, bonds did a much better job of protecting investors against inflation in periods of rising interest rates than shares.

Historically short-term US treasury bonds have behaved as a haven asset during market turmoil.

WHY INFLATION-PROTECTED BONDS ARE NOT PERFECT

Bonds with in-built inflation protection are called inflation-linked gilts or ‘linkers’ in the UK and treasury inflation-protected securities or ‘TIPS’ in the US. Gilts and treasuries are common terms for UK and US government bonds, respectively.

Inflation-linked bonds work by applying an adjustment to the interest payments and capital repayment based on accrued inflation.

It might seem like a good idea to buy bonds which promise to increase interest payments in line with future inflation. However, it isn’t straightforward and there are advantages and disadvantages to weigh up.

The UK linkers market was created for insurance firms and pension funds to solve their needs to hedge liabilities, often a long way into the future. Linkers generally have a long maturity profile with an average duration of around 17 years.

Duration is the weighted average time left until a bond matures and the loan is repaid. It is also a measure of the sensitivity of a bond price to a move in interest rates.

For example, a bond with a 17-year duration can be expected to lose 16.6% of its capital value for every 1% move higher in interest rates. Exchange-traded fund iShares Index Linked Gilts ETF (INXG) is down 19% year-to-date and has a duration of around 21 years.

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The high sensitivity of linkers to interest rates is a serious drawback when considering them as an inflation hedge.

There are ways to separate the duration element from the inflation element but that is beyond the scope of this article.

WHAT ABOUT CORPORATE BONDS?

Corporate bonds are debts issued by companies to raise money for various corporate purposes. They are risker than government bonds and behave more like shares, and they are sometimes referred to as credit products.

Until recently corporate bonds of low-quality companies had performed well compared with high-quality bonds.

It’s important to look at the high-yield bond spread. This is the difference in the yield on high-yield bonds and a benchmark such as investment-grade corporate bonds. In general, the riskier the company, the higher the yield you would expect to find on its bonds.

The high-yield spread was until recently at historically low levels of around 3% according to St Louis Federal Reserve data.

Although the spread has widened out to 4.5% in recent weeks, the current economic backdrop is not favourable for companies with lots of debt and/or operational or strategic challenges, which you often find with those whose bonds come with high yields.

Therefore, we would steer clear of low-quality high-yield corporate bonds and only look at ones linked to higher-quality companies.

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THREE BOND FUNDS TO BUY

Lyxor FTSE Actuaries UK Gilts ETF (GILS)

The £671 million exchange-traded fund’s objective is to track the performance of the FTSE Actuaries UK Government Gilts All Stocks index. The ETF fully replicates the index in a cost-effective manner.

The ETF is down 9.5% year-to-date and has a trailing 12-month yield of 2.1%. Income is paid twice a year and the annual ongoing charge is 0.05%.

Roughly 44% of the portfolio has a maturity of under 10 years, giving a good balance between short and longer dated maturities.

Remember, we’re taking the view that bond prices and yields are looking more attractive because of the recent market movement. So don’t simply look at the recent performance and assume this ETF isn’t worth buying because the returns have been negative.

M&G Global Macro Bond Fund (B78PH60)

Manager Jim Leaviss is one of the most experienced in his field and has managed the M&G fund for over 20 years.

He is assisted by Eva Sun-Wai and the pair also benefit from the breadth and depth of the wider M&G investment team.

The $1.74 billion fund aims to deliver a higher return than the IA Global Mixed Bond Sector over rolling five-year periods.

The fund has delivered five and 10-year annualised returns of 1.6% and 4.2% respectively, beating the benchmark.

Dividends are paid quarterly, and the trailing 12-month yield is 0.8%. The portfolio has a duration of around seven years and the fund has an ongoing charge of 0.63% a year.

The managers have a defensive positioning with very little exposure to corporate bonds, although exposure was increased as spreads widened in March.

The duration of the fund was also increased in March based on the managers’ view that further aggressive monetary tightening could curtail economic growth in 2023.

iShares Core Global Aggregate Bond ETF GBP (SAGG)

The $5.62 billion fund is designed to give investors exposure to global bonds and tracks the performance of the Bloomberg Barclays Global Aggregate Bond index.

The fund is a flagship measure of investment-grade government and corporate bonds across 24 local currency markets. It provides broad diversified access to 9,400 bonds for a charge
of 0.1% a year.

The currency exposures within the fund are not hedged which means returns to UK investors will include other countries’ currency movements relative to sterling.

The portfolio pays out dividends twice a year and has a trailing 12-month yield of 1.4%.

In terms of geographical exposure, the fund has 43% invested in the US, 22.5% in developed Europe and 13.7% in Japan. The fund’s exposure to the UK is around 5%. 

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Why the chances of central bank policy mistake are high

One thorny problem facing central bankers is that normal measures of economic growth and monetary conditions have been heavily distorted over the last two years.

The pandemic caused the immediate closing of the global economy. The surprisingly quick discovery of effective vaccines subsequently led to a relatively fast reopening of economies.

The double-shock to the global economy created unforeseen supply chain disruptions and even labour shortages, pushing up inflation. The invasion of Ukraine has exacerbated these effects.

In short, no-one really knows if the growth in the global economy is being driven by genuine overheating or because of the lingering but temporary effects of normalisation after two massive shocks.

Fund manager James Harries at Troy Asset Management likens the enormous monetary and fiscal stimulus provided by the authorities in response to the pandemic to stimulus provided to counter Y2K issues in the late 1990s.

With the benefit of hindsight both crises turned out to be less debilitating to the economy than initially feared. The extra stimulus led to speculation and a misallocation of capital.

In the late 1990s this contributed to the final ‘blow-off’ which culminated in the bursting of the dotcom bubble.

Retail investor frenzy seen during lockdown and the emergence of meme stocks suggests something worryingly similar could be happening today.

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