Bond funds sector review – volatile times ahead?

Bonds rebounded over the last quarter, in part linked to recovering from the UK’s ill-fated mini-budget back in September. But interest rates have continued to rise and inflation is still stubbornly high. So, what’s going on and what does this all mean for bonds?

This article isn’t personal advice. If you’re not sure whether an investment is right for you, please ask for financial advice. All investments can fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

What’s the latest on interest rates and inflation in the UK?

High inflation and rising interest rates have been bad for bonds.

2022 was the worst calendar year on record for the US investment grade bond market (Treasuries and corporates combined). And for other types of bonds where it wasn’t the worst on record (like high yield bonds), it was still pretty bad compared to history.

UK inflation hit 10.1% in January, down from 10.5% in December. This has come down a little since a peak of 11.1% in October, but is still way above the Bank of England’s 2% target. In the US, inflation fell from 6.5% in December to 6.4% in January. It’s now well below its peak of 9.1% in June. For Europe, it was 9.2% in December from a high of 10.6% in October.

The pattern is that inflation is coming down in the western world. The expectation is that this will continue over the coming months, with things like energy price increases falling out of the one-year headline inflation numbers by April.

Is that job done then? Not quite and central banks know this.

In the UK, a further rise of 0.5% was announced in February, taking the base rate to 4%. The US and Europe also chose to increase rates in February, by 0.25% and 0.5% respectively, taking their base rates to 4.75% and 3%.

What’s happening in the bond market?

While 2022 for the most part was pretty dreadful for bonds, fortunes did change towards the end of last year.

The three months to the end of January generally saw bond values rally and yields fall (bond yields move in the opposite direction to bond prices).

Looking at the yields on 10-year government bonds from the UK, US and Germany (a proxy for Europe), on 31 January 2023 these sat at 3.3%, 3.5% and 2.3% respectively. At the end of October 2022, these were 3.5%, 4.1% and 2.2% and peaked at 3.8%, 4.2% and 2.6% during the three months to the end of January. German bond yields were the only ones to increase over the period, but they’re lower now than their peak.

This meant that a lot of bonds saw positive returns over the three months, with corporate bonds in particular doing well. The IA £ Corporate Bond sector average performance was 5.88% over the three months. The IA £ High Yield sector average was similar at 5.80% and the IA Strategic Bond sector average was 5.74%. The IA UK Gilts sector average posted a modest gain of 0.72%.

This all feels a bit odd. Rising interest rates reduces the appeal of bonds that largely pay fixed amounts of return, because holding cash rather than bonds becomes more appealing on a relative basis. Similarly, inflation means that the fixed interest payments made by most bonds are worth less in the real world. So why haven’t bonds continued to fall in value?

This all comes down to expectations. By the time we had got to the end of October, investors already expected interest rates to keep rising and for inflation to remain high. This was already priced into bond values.

What’s happened since has largely been as expected. Investors like this, or rather, what investors don’t like are surprises. The relative lack of surprises (certainly in comparison to the rest of 2022) has meant that investors have become less scared and have calmed a little over the last three months.

What happens from here is difficult to assess, and depends on what happens with inflation.

If inflation continues to fall, then rate rises can be expected to slow and/or stop. At some point, there could even be some interest rate cuts. This would be good for bond values (but would decrease yields).

However, if inflation is sticky and only falls slowly, interest rates could remain at current levels or higher for some time. It’s difficult to say what that will mean for bond values, but what’s likely is that investors will react to data as it arrives. This could mean more ups and downs for bond prices until things become a bit clearer and an end to high inflation more certain.

How have our fixed income Wealth Shortlist funds performed?

Our Wealth Shortlist bond picks have delivered mixed performance over the past year. Some have outperformed their peer group, and others have underperformed. We wouldn’t expect them all to perform in the same way though. If all your funds in a sector are performing well at the same time, they're probably investing in similar areas.

Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.

For more details on each fund and its risks including charges, please see the links to their factsheets and key investor information below.

The best performing Wealth Shortlist fixed income fund over the last year was M&G Global Macro Bond with a return of -1.35%*. Past performance isn’t a guide to the future.

Jim Leaviss and Eva Sun-Wai start with a 'bigger picture' macroeconomic outlook. This includes forming a view on economic growth, interest rates and inflation globally. This then helps them decide how much to invest in different areas of the bond market and different currencies.

Leaviss has historically used the flexibility afforded to him in the fund to good effect to deliver strong returns for investors. We believe experience is vital for a manager of this type of fund and Leaviss is one of the most experienced bond fund managers in the UK.

The fund’s exposure to the US dollar has helped performance over the last 12 months. The managers have been defensively positioned, due to concerns around inflation and rate rises, and this has also helped to keep losses lower than their peers. But the bonds they hold have still lost value.

MORE ABOUT M&G GLOBAL MACRO BOND, INCLUDING CHARGES

M&G GLOBAL MACRO BOND KEY INVESTOR INFORMATION

The worst performing Wealth Shortlist fixed income fund over the last 12 months was the Legal & General All Stocks Gilt Index fund, returning -18.79% over the period. As always, past performance isn’t a guide to the future.

The fund offers a simple way to invest in UK government bonds across all maturities. It can help diversify a portfolio focused on shares or other types of investment. Inflation and rate rises have resulted in the fund losing money over the period. As this is a passive fund that aims to track the market, performance isn’t down to the decisions of the manager.

MORE ABOUT LEGAL & GENERAL ALL STOCKS GILT INDEX INCLUDING CHARGES

LEGAL & GENERAL ALL STOCKS GILT INDEX KEY INVESTOR INFORMATION

Past performance isn’t a guide to the future. Source: *Lipper IM, to 31/01/2023.

Past performance isn’t a guide to the future. Source: Lipper IM, to 31/01/2023.