Bonds

Investors can get exposure to bonds through funds run by a fund manager, but there are several different types of bond funds:

• Corporate bond funds – focus on higher-quality, investment grade bonds issued by companies. Compared to high-yield bonds they have a lower risk of default because they are more likely to be able to repay their debts. They tend to offer lower yields as a result.
• High-yield bond funds – invest in bonds paying higher levels of income. This compensates investors for the extra risk taken, because these bonds are issued by companies that are less likely to be able to pay off their debts.
• Strategic bond funds – have the freedom to invest across the bond markets, including government, corporate and high-yield bonds. They also have some flexibility to invest overseas. Some focus more on paying a high income. Others focus more on growing or sheltering investors' wealth.
• Global bond funds – invest in government and corporate bonds issued globally. They also hold bonds denominated in currencies other than sterling. This means they might have a lot of exposure to foreign currencies. Similar to strategic bond funds, their objectives vary from fund to fund.
• Gilt and index-linked gilt funds – mainly invest in bonds issued by the UK government. They typically have a lower risk of default and lower yields than corporate bonds. Index-linked gilts typically increase any income paid, and the capital repaid at redemption, in line with inflation.

Our view on the Bonds sector

Bonds usually pay a fixed rate of interest. So they can be useful to generate an income. They're often viewed as ‘lower risk’ than investing in a company’s shares. This means they can help limit some of the volatility that normally comes with investing purely in the stock market. We believe bonds can play a part in a diversified portfolio. But there are still risks when investing in bonds.

The main risks to bond investors are a faster-than-expected rise in inflation or interest rates (interest rate risk), a slowdown in economic growth that makes it harder for companies to pay their debts (default risk), or a broad sell-off across the market that makes it difficult to sell bonds at a reasonable price (liquidity risk).

Liquidity risk usually comes following an unexpected event and is therefore difficult to predict, but it can have a significant negative impact on bond prices over the short term.

Default risk is usually more relevant to individual bond issuers such as companies or governments. The company or government doesn’t have to actually default to impact the price of the bond, it only takes investors thinking the chance they might default has increased. This is because if an investor thinks the probability of a default is higher, they will expect a higher level of return to compensate for the perceived higher risk. As the returns on bonds are largely fixed, the price of the bond has to fall to make future returns higher. Of course, if the risk of default reduces, then you can expect the opposite to happen and for the bond to increase in value.

Investing in a bond fund should reduce default risk compared to investing in an individual bond due to diversification across multiple companies or governments. When the economy is in recession though, there is greater potential for multiple companies to have a higher risk of default at the same time, which could be negative for bond markets more widely.

Interest rate risk is a common cause of bonds losing value. When central banks increase interest rates, this makes the yields available on bonds less attractive. In turn, bonds typically fall in value because of reduced demand from investors. Bond yields and values move in opposite directions, so as bonds fall in value, their yield rises. Bond prices usually settle at a level where the yield is attractive compared to interest rates again. If interest rates fall, this should be positive for bond values for the opposite reasons to those noted above.

Within the different types of bonds, developed market government bonds specifically are considered to be ‘safe haven’ assets. This means that they are expected to increase in value when other markets are selling off and potentially vice versa.

The reason for this is that investors feel confident that governments such as the UK or US will not default on their debt, so investors expect to at least get their money back. When stock markets are falling and investors are not sure what will happen with share prices, they typically sell company shares and invest the proceeds into government bonds. Once stock markets have settled and start to rise again, it is common for those same investors to sell their bonds and buy more shares again. This investor behaviour can have a significant impact on the prices of government bonds.

Our Wealth Shortlist features bond funds chosen by our analysts for their long-term performance potential.

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