Why bonds could still be a good buy for you as the bubble refuses to burst

The experts may be divided on them but they can have a place in private investors' portfolios, reports Julian Knight

Almost from the moment that the bond market shook off the malaise following the global financial crash - long before shares managed the same trick - there has been speculation that a bubble was developing. Long-standing market watchers did the numbers as long ago as 2011 and suggested that bonds were set for a battering. However, to date those predicting a crash have been proved spectacularly wrong as returns have continued to come in apace with lower-than-expected default rates. Although yields - in effect the amount of interest the bond earns - have fallen back as the economy has surged back into life and corporates and governments found it easier and cheaper to raise capital, bonds continue to play a more than healthy role in private investors' portfolios. Not so much crash as cruising along nicely.

"The bond bubble is a phrase I hate and I think many managers are beginning to regret using it. So many experts and top managers have presumed that we would have had dramatic falls by now but it hasn't happened," said Hargreaves Lansdown director Mark Dampier. "In some ways they have been a victim of presuming history will repeat itself. They look at previous experiences of emerging from recessions and market corrections and presume that by now we would start to see bonds as overpriced. However, this time around we are in a new world where interest rate cycles may only take us up to 2 or 3 per cent and as a result even these low bond yield rates could keep their attractiveness to investors."

There are two factors which have a major impact on the bond market and ultimately the fortunes of those who invest in bonds or bond funds. These factors are interest rates and the health of the economy. Generally, rising interest rates mean that the yield on bonds looks less attractive and therefore investors are likely to buy fewer. As for the wider economy, a troubled economy often means high default rates which can hurt bond returns and even lead to loss of capital, as Mr Dampier explains: "During the financial crash some bond funds lost half their value, high yield bonds in particular are a risky investment - that is why they pay a higher yield. Bonds are far from safe investments in the same way as cash."

The current economic and interest rate environment would suggest that bonds are not set to fall out of bed as they did in 2008 or as they have done following bubble scenarios in the past. Brian Dennehy, a director of Fundexpert, says the jury is very much out on bonds and the bursting of any bubble. In truth Mr Dennehy sees a soft landing for bond investors but nevertheless price declines are on the cards :"The average UK corporate bond fund made money in 2013, although not a lot, up 0.35 per cent. But it is difficult to see how corporate bond funds, on average, can do even this well in 2014. I say 'on average' deliberately. The worst such fund was down nearly 3 per cent in 2013, but the best were up a little over 5 per cent."

The trouble is that many bond fund managers have never had to deal with a difficult market - unless of course they were invested in high risk, high yield bonds at the time of the financial crisis - "the past 30 years has been bonanza time for bond fund managers, as yields have fallen from double digits, pushing up capital values, and often doing better than the stock market".

But that bull trend for bonds is probably over. And no bond fund manager has experience of having to make a turn in a long-term bear market for bonds. The best of them might well make money - derivatives provide much flexibility to slice and dice the bond returns, and even make money as capital values fall, Mr Dennehy says.

As a result, he cautions investors to reduce their exposure to bonds over the next year or two - anticipating at best sluggish returns if not outright falls.

Some bond fund managers though have been more pessimistic and suffered the consequences as a result. For instance, William Littlewood, renowned head of the Artemis Strategic Assets fund, is just one manager who has bet quite big on a falling market only to count the cost. Fortunately, Mr Littlewood's equity investments have ridden to the rescue. Other bond managers haven't been so lucky and as a result have underperformed: "Many of the managers have bet on a bursting of the bond bubble but have lost out as a result - some have been betting on it for two or three years," Mr Dampier said.

Yet Darius McDermott, managing director at Chelsea Financial Services, reckons that any growth to be had in bonds is going to come from managers like Mr Littlewood and the Jupiter and Henderson Strategic Bond funds (the Jupiter fund is also tipped by Mr Dampier) who are able to be nimble and hedge against bond values taking a dive.

"We've been saying for some time that if you do want to invest in bonds then strategic bond funds are the way to go. They have the flexibility to invest in all types of bond assets and find pockets of value where they do occur, and they have more tools available to them to manage interest rate risks better," Mr McDermott said. But this doesn't mean that he is a huge fan of bond investment right now. It seems his view is that strategic bond managers are best placed to make the best of a bad job.

"We would still struggle to say it is an attractive asset class... however, having said all this, bond funds do still play a valuable role in portfolios. Not only do they give diversification, but they are also a source of income, which is a necessity for many. As long as a bond fund is paying around 4 per cent, in our view it is a good source of income and the majority of returns going forward will be from the income rather than capital appreciation," he said. But that doesn't sound like the long-foretold bond market bubble bursting.

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