Mark Dampier: Corporate, high-risk, strategic, high yield ... the word is bonds

 

It is possible to trace the bond market's strong run as far back as the early 1980s, when US interest rates peaked. We have since seen a long period of falling bond yields (and rising prices), though it has not always been a smooth ride.

The past five years have been particularly strong as interest rates were cut aggressively in response to the financial crisis. Investors' insatiable appetite for income and the gradual realisation that rates were not going back up to 5 per cent increased bonds' popularity. This demand has driven yields down (and prices up).

At the time of writing, European high-yield bonds yield less than 4 per cent on average, an all-time low which barely compensates investors for the risks.

The positive case for bonds at these levels relies on a low-inflation, low-interest rate world where the economy continues to recuperate (without growth running away). An improving economy helps companies to strengthen and allows them to reposition and rebalance. If this transpires, corporate bond investors receive a modest yield and remain happy.

For the moment, inflation remains below the Bank of England's 2 per cent target, and the interest rate outlook remains relatively benign.

Some commentators believe rate rises could come as early as November. In my view, interest rates will not rise until after next May's general election and, while this is by no means certain, I still feel it is the most likely outcome.

Furthermore, while the media obsesses over the timing of the first move in interest rates, their eventual path is far more important. On this the Bank of England has been quite clear: when rates do start to rise, they will do so slowly, in small increments, and they will eventually stabilise at much lower levels than we saw pre-crisis.

Rising interest rates and inflation are not the only risks. High-yield bonds, in particular, are sensitive to economic conditions. At current yields and prices, any slight deterioration could cause a sharp fall in the bond market.

I don't believe there is cause for panic, but it is sensible to periodically review your overall exposure to bonds and the types of fund held to ensure they continue to meet your objectives.

In the current environment, I favour strategic bond funds which can invest across the fixed-interest spectrum, from government and corporate bonds to higher-risk high- yield bonds. They also have the ability to invest overseas, potentially benefiting from currency movements, while derivatives can also be used to profit from price falls.

I recently caught up with Ariel Bezalel, manager of the Jupiter Strategic Bond fund. Interestingly, while many commentators are increasingly cautious in their outlook for high-yield bonds, Mr Bezalel doesn't yet see "the death of high yield". Around two thirds of the fund is invested in high-yield debt, which includes 25 per cent in subordinated bank debt (these bonds rank lower in the pecking order if a bank defaults on its debt).

Around two thirds of this high-yield bond exposure is invested in bonds secured against specific assets, such as property or oil rigs. These bonds can offer attractive yields, but in the event of default the bondholders have a claim over the assets, which they could sell to recover some losses.

Mr Bezalel is aware that bond yields are likely to drift higher over time, but he does not anticipate a 1994-style scenario, especially as interest rates are unlikely to move too high, too fast.

To mitigate some of the impact of rising interest rates, the fund's duration (sensitivity to interest rate rises) is 2.2, compared with 7.7 for the Markit iBoxx Sterling Corporates Index. The portfolio's lower duration is achieved by using its flexibility to invest in derivatives. For instance, the fund is currently short US Treasuries which, while reducing duration, could also prove profitable if US government bond yields rise, and prices fall.

The fund currently yields 6 per cent and also has the potential to offer some protection when interest rates rise. This does, however, rely on the manager making the right calls, and if he gets it wrong, greater volatility should be expected.

Overall, I believe that it is increasingly important for bond fund investors to focus on flexible funds with experienced managers at the helm and I continue to rate Ariel Bezalel highly.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.hl.co.uk

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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