Stubbornly high inflation figures mean we are now expecting interest rates of almost 6 per cent in the UK, something that anyone under the age of 30 will not have experienced during their working careers.

It has also changed the dynamics of markets — high-growth companies are no longer the “go-to solution” for investors as they were in the days of quantitative easing and, all of a sudden, UK corporate bonds are starting to look a sensible choice to navigate the continued uncertainty in markets.

Figures from the Investment Association show the Sterling Corporate Bond sector has seen almost £1bn of net inflows in the first four months of 2023, a sharp contrast from the outflows seen in recent years.

For clarity, the yield on a corporate bond fund is made up of two parts: the risk-free rate (that is, gilts) and the spread (the difference in yield between the corporate bond yield and the risk-free rate on government bonds). Spreads are historically attractive on fixed income, but not at the levels we saw on the back of the global financial crisis or Covid-19 when interest rates were at record lows.

At the time of writing, the two-year gilt stands at just over 5.2 per cent, so you should be looking for around 7 per cent from a UK corporate bond (2 per cent above the risk-free rate).

This is a rare environment for the sector for a number of reasons. Not only is it unusual to see both elements — the gilt yield and the spread — so high, but as Artemis Corporate Bond fund manager Stephen Snowden points out, the sector incurred severe losses in 2022, the worst in 40 years of recorded data.

Not only is the income as healthy as you could ask for, but the risk is lower than it used to be. The bond market is full of bonds issued during the QE era, with lower coupons and the prevailing yield offered today.

Snowden says the average price of a bond in the sterling corporate bond market today is 87p in the pound. Essentially, for every £100 claim on a company you are paying £87 on average across the sector.

There are dangers

I agree investment-grade bonds look attractive, but it is far from a bombproof option given the growing threat of recession. While I am bit calmer over the energy concerns, every day that passes with rates and inflation at these levels poses significant threats to the housing market.

The stress is only starting to come through as people come off fixed-term deals and are faced with significant increases in their mortgage repayments in this rising rate environment. One million UK mortgage holders could see their disposable income fall by 20 per cent because of rising rates, according to the Institute for Fiscal Studies.

The thing that will hit hard in a recessionary environment is the spread. It does not matter what the gilt is, the spread will widen. Remember: if yields go up, bond prices will fall — but you are being compensated for this risk at these elevated yields.

One of the main underlying reasons for inflation remaining high is goods inflation, which has continued to creep up. The employment market is also strong, promoting wage inflation as well.

Snowden says estimates indicate that inflation will be in the region of 3 to 4 per cent in the next 10 years. That scenario makes corporate bonds incredibly attractive as you will get a decent yield now and if those rates go down, bonds will rise and you will get a capital uplift.

Liontrust Sustainable Future Monthly Income Bond fund co-manager Jack Willis says there is a real risk that the UK falls into recession in the coming months and consensus forecasts, while upgraded so far this year, are still for muted growth over the next few years.

The world of volatility will lead to a bigger discrimination between strong and weak companies

Stephen Snowden, Artemis Corporate Bond

He adds that following recent stronger-than-expected inflation data, markets have priced in several further hikes, taking the market-derived peak in base rates to 6 per cent or higher. But with the economic growth outlook anaemic and inflation likely to fall back belatedly towards the Bank of England’s 2 per cent target next year, the case for further rate increases is limited.

“The bond market is currently very focused on short-term trends in macroeconomic data, such as inflation prints, as it attempts to call the peak in base rates, so we expect more volatility over the course of this year as sentiment fluctuates,” Willis says.

“But we think long-term investors should view this short-term noise as a mispricing opportunity — with base rates close to peaking, we think current UK government bond yields of 4.4 per cent (10-year bonds) are very attractive.”

Dispersion opens the door to active

The last point I want to highlight is that this is a good time to take the active management route for investment-grade bonds. There is currently a deluge of gilt issuance in the market during this inflationary backdrop (around £277bn for financial year 2023-24) as this is now a quantitative tightening scenario — the Bank of England is adding rather than buying the supply. There is plenty of choice around for managers.

In addition to the greater supply, Snowden says the end of QE has created greater dispersion in investment-grade bonds. He says: “During 2008, you had bank bonds trading at 10p to 30p in the pound, whereas utility/telecom bonds were being treated like royalty. Bonds were either incredibly cheap or expensive — very few bonds traded at the average level.

“Then we had QE and GBP investment-grade dispersion came in and started to trade at the average level. But we are starting to see post QE an increase in dispersion across companies again. The world of volatility will lead to a bigger discrimination between strong and weak companies.”

M&G Corporate Bond fund manager Richard Woolnough says credit valuations can differ quite dramatically between sectors such as real estate and financials, where spreads remain quite wide, and other sectors such as healthcare and capital goods, where spreads are significantly tighter.

Woolnough says: “As a result, top-down asset allocation will remain important, but it is likely that bottom-up security selection will also have an important role to play. We believe that a global, flexible and selective approach will therefore be key to unlocking returns.”

Corporate bonds are very much back on the agenda. Yes, there are still some risks, but you are being rewarded handsomely for taking them.

Other funds to choose from:

Royal London Corporate Bond

The managers of this fund delve into parts of the fixed income market where others fear to tread and identify bonds that offer superior risk-adjusted returns. The process is risk-aware and concentrates on avoiding losers rather than picking big winners. The fund is well-diversified with around 200 names.

TwentyFour Corporate Bond

This fund looks to achieve the highest possible income with the least amount of volatility. To find his holdings, manager Chris Bowie uses a bespoke quant research tool: Observatory System, which is designed to seek out the best risk-adjusted opportunities.

The fund will only hold a maximum of 100 stocks at any one time, so that Bowie can let the benefits of good stock selection shine through.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre

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