The bond funds proving their worth

As investors shun government debt and focus on rising inflation rather than the risk of a recession, corporate bond funds are proving surprisingly resilient during the energy crisis.

Since the Iran war broke out at the end of February, the 10-year UK gilt yield has increased from 4.2 per cent to 4.7 per cent, as investors sell UK government debt. Government bonds tend to be less attractive in the face of rising inflation as real yields (the nominal yield minus inflation) fall. In the UK and Europe, investors have also become concerned that governments would have to borrow to help citizens cover rising energy costs, and the UK’s reliance on energy imports has made gilts particularly vulnerable.

Jason Hollands, managing director at Bestinvest, said that government bonds had not behaved as some might expect in a geopolitical shock.

“Yields have moved higher as markets dial back expectations for rate cuts. In effect, the inflationary impulse from higher energy costs is outweighing the usual safe-haven bid,” he said.

The chart below shows how the main fixed-income fund sectors (as defined by the Investment Association) have performed since the start of the war.

No sector escaped unscathed, other than cash-like money market funds. However, corporate bonds are among the least affected. The sector tends to struggle when investors worry about a recession, as this can lead to more defaults. When that concern takes centre stage, the ‘spread’ (the gap between government and corporate bond yields) increases.

Bryn Jones, head of fixed income at Rathbones Asset Management, said the resilience of corporate bonds had surprised him. Spreads initially increased before tightening as government bonds sold off, while corporate bonds remained steady.

“Investors continue to search for yield, and the all-in yields, especially for investment-grade corporate bonds, have seen some incredible stability,” he added.

James Flintoft, head of investment solutions at AJ Bell, agreed. “With geopolitical risk elevated and the growth outlook deteriorating, we might have expected [more selling],” he said. “Whether that restraint proves well-founded or simply reflects a lag remains to be seen.”

Strategic bond funds

Strategic bond funds, whose managers invest across different types of debt and can shift allocations to match markets, have lost 1.4 per cent over the period, on average.

Some of the best performers were Man Dynamic Income (IE000RA2ZI45), which is up 0.6 per cent, FTF Brandywine Global Income Optimiser (GB00BNBS6274), up 0.3 per cent, and Fidelity Strategic Bond (GB00BCRWZS59), which is flat.

Man Dynamic Income has essentially no exposure to government bonds, and more than 70 per cent of the portfolio is invested in high-yield bonds (with ratings of BB or B, below the traditional investment-grade level). The fund has been a top performer in the past three years, but it is riskier than its competitors. In their March commentary, the managers said that the funds with the largest losses tended to be those backing AT1s or with longer-dated debt. AT1s are typically the riskiest and highest-yielding bank bonds. Man’s portfolio was shielded by its relatively low duration going into the war, the managers added.

FTF Brandywine Global Income Optimiser also backs high-yield bonds, with more than half of the portfolio below investment-grade level and just a fifth in government bonds. The fund also has more than half of the portfolio in the US, about a fifth between Brazil, Mexico and Argentina, and very little in the UK or Europe.

The Fidelity fund bucked this trend and was mostly invested in government bonds, but with a significant amount in Latin America rather than Europe, where losses were higher.

Investors’ Chronicle’s strategic bond fund of choice, TwentyFour Dynamic Bond (GB00B57TXN82), a member of our Top 50 Funds list, lost 1.4 per cent over the period. One of the fund’s managers, Felipe Villarroel, argued that the narrowing spread between corporate and government yields showed the market was becoming riskier. He said investors should remain cautious because if the war ended, there would be a small relief rally for government and corporate bonds, but if hostilities worsened, corporate debt could sell off significantly.

“We continue to focus our exposures on higher-quality credit, while having a reasonable amount of liquidity to buy credit if spreads do widen from here,” he added.

What comes next?

Much will depend on how the war unfolds. “The key question will be whether inflation or growth concerns become more prevalent,” Hollands said. “That’s hard to call when we’ve flip-flopped between escalation, de-escalation and back to escalation within the space of a week.”

Despite their comparatively high prices, Flintoft said corporate bonds were still worth considering. “Even with tighter spreads, they provide a return cushion that is useful in navigating inflation, particularly given it will probably be above central bank targets over the long term,” he said.

He added that the area he was more optimistic about was short-term index-linked bonds, which offer “meaningful inflation protection” but without the risks of longer-dated debt.

“When inflation spikes emerge – as they have – [short-dated linkers] have provided exactly the stability we were looking for and yields have repriced accordingly,” he said.