Bonds have been in the spotlight ever since Ben Bernanke, chairman of the US Federal Reserve, suggested American quantitative easing could be tapered this year. Investors interpreted this as the first stage towards an rise in interest rates, which would be negative for bond markets.
Bonds pay a fixed level of income, which looks less attractive against a backdrop of rising interest rates. Bond prices have therefore fallen in recent weeks, and yields (the fixed income divided by the price and expressed as a percentage) have correspondingly risen. Equity markets were also hit, perhaps as investors saw an excuse for profit taking after a strong run. In both cases emerging markets fared worst, with equity and bond markets falling around 10 per cent.
I think even Mr Bernanke was surprised by the reaction of investors. While equity market falls could be put down to profit taking, for bonds the problem is somewhat greater. Bonds have enjoyed a bull market since 1990 and yields are at historic lows. Everyone knows interest rates will have to go up one day. The trouble is neither commentators nor central bankers really know when. That day must be drawing closer.
Investors face a conundrum. While sovereign debt, such as gilts and US treasuries, doesn't yield much it is still possible to get yields of around 3 per cent from corporate bonds. This compares favourably with UK deposit rates, which have fallen further to no more than around 1.5 per cent, but it does involve taking some capital risk.
For investors who still want some bond exposure I believe strategic bond funds should be considered. These give managers the freedom to invest across the fixed-income spectrum, wherever they see the best opportunities. They also have the flexibility to use derivatives and alternative techniques such as shorting, to provide some relative capital protection in a falling bond market. This is of course reliant on the fund managers making the correct decisions and there are no guarantees.
One of my favourite funds in this area is the Invesco Perpetual Tactical Bond fund, managed by Paul Read and Paul Causer. The fund has no constraints over geography, sector or credit quality. It is a portfolio of their very best ideas with a focus on generating a combination of capital growth and income over the long term, rather than focusing solely on income. Key to their approach is identifying undervalued opportunities which they believe will add significant value when markets are rising. They will also seek to shelter capital when opportunities are lacking.
The managers began shifting the portfolio to a more defensive stance before Mr Bernanke's speech. They held a significant cash position, but were still achieving a portfolio yield in the region of 5 per cent. They expect the recent falls to be the first stage in the global readjustment brought about by a stronger US economy. Despite their sombre outlook they believe ongoing volatility will continue to throw up good opportunities.
Overall the cash and short-dated bond positions (the managers view short-dated and government bonds as near-cash positions which can be sold quickly) comprise around 60 per cent of the portfolio. They suggest the portfolio should therefore be well positioned for turbulence and with sufficient liquidity to take advantage of buying opportunities.
The balance of the portfolio is largely invested in the financial sector and this remains an important component of Mr Read and Mr Causer's strategy. On balance they have been rewarded for the risks taken in this area of the market. However, exposure to higher-risk high-yield bonds and financial bonds has recently been reduced. They continue to believe yields are attractive in this area of the market, but see less scope for capital growth as the sector has rallied over the past year.
For investors cognisant to the risks in the bond market, but still wanting some exposure, the Invesco Perpetual Tactical Bond fund could be an ideal component of a well-diversified bond portfolio. It is still difficult to see interest rates in the UK rising before the next general election in May 2015 and income is still a priority for many investors. I am therefore not sure the bond story is entirely over. That said, investors must recognise we are at the beginning of the end of the bond story and the eventual transition to higher interest rates will not be an easy one.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial advisor and stockbroker. For more details about the funds included in this column, visit www.hl.co.uk/independent