Most investors get exposure to bonds through funds run by a portfolio manager. There are several different types of bond fund:
- 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 and 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 a number of risks have built up that investors should be aware of.
Bond markets have performed well over recent years, but as a bond’s price rises its yield falls. Yields are now at historically low levels. This means the scope for significant further gains is limited and the income on offer has reduced. There's lower potential reward on offer for taking on the risks of lending to companies and governments. There's also more room for yields to rise and prices to fall. This means investors could see more volatility in this area of the market than they've been used to in recent years. It increases the potential for losses.
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).
That’s not to say bonds should be ignored completely. They still have the potential to perform well and have provided some shelter over the past year during times when share prices have faltered. This highlights the benefits they can potentially bring to a diversified portfolio. While we don’t think interest rates will rise quickly in the short term, it’s important investors are aware of the risks associated with investing in bonds.
Our favourite bond funds feature on the Wealth 50. We currently prefer strategic bond funds because they have the flexibility to try and make returns from all areas of the bond markets.
Investors who prefer a professional fund manager to run a diversified portfolio of bond funds for them could look at the HL Multi-Manager Strategic Bond Trust. We think the additional costs of a multi-manager fund are justified by the extra layer of oversight from experienced investors. The HL Multi-Manager funds are managed by our sister company HL Fund Managers.
Bonds performed well over the past year, and delivered better returns than many of the world’s major stock markets.
In the wake of the 2008 global financial crisis, central banks around the world cut interest rates and started buying government bonds on a massive scale. These actions helped to push up bond prices, but yields down to historically low levels.
Bond prices were more volatile last year as investors expected central banks, mainly the US Federal Reserve, to start raising rates at a quicker pace. 2018 also saw the start of quantitative tightening – the process of reducing central banks’ holdings of government bonds.
Early this year, the Fed softened its stance on raising rates and cut them for the first time in a decade at the end of July. Other central banks have joined them in striking a tone markets have viewed favourably, and this has supported bond prices so far this year.
Back home, the UK’s future relationship with the European Union became even less certain. Boris Johnson's appointment as Prime Minister increased speculation that a hard or no-deal Brexit is on the cards. Against this uncertain backdrop, UK investors looked for shelter in gilts, which are often seen as a safe haven.
Higher-risk bonds delivered the best returns over the year though. High-yield bonds typically offer a better rate of interest because the companies behind them are seen to be less financially secure. The expectation interest rates will remain lower for longer means it’s more likely these companies will be able to repay their debts.
What's happened to the yield curve?
In August, the yield curve for 2-year and 10-year US Treasuries inverted for the first time since 2007.
Typically, the longer you lend money to a government or company, the more you expect them to pay because of the greater risks involved. There's more chance they might default and not be able to pay off their debts, for example.
But the yield curve inversion means the 10-year bond yields less than the 2-year bond. So investors are in the unusual situation where they'll accept lower returns for lending over a longer period than a shorter one. It also means they expect lower economic growth and interest rates in future.
An inverted yield curve has historically been an indicator of a coming recession. The one thing it can't predict is when this might happen. A potential recession could be months or years ahead of us.
And there might not be one at all. There's been false signals in the past and it could just be a sign investors are nervous. The actions of central banks has also helped to manipulate bond prices over the past decade, and this could be having an impact on the way markets behave.
Our favourite funds in the sector
For more information, please refer to the Key Investor Information Document for the specific fund risks. Remember all investments can fall as well as rise in value so investors could get back less than they invest. Past performance is not a guide to the future.
Other funds in this sector
Here we look at some other funds of interest following our most recent sector review. Please note the review may be over a short time period and past performance is not a guide to future returns.
Source for performance figures: Financial Express
Corporate Bond. This fund mainly invests in investment grade corporate bonds. The managers are prepared to be flexible and invest the fund differently to other corporate bond funds. This means performance can look quite different and the fund can be higher risk.
The managers have taken a fairly cautious approach in recent years, as they thought the environment for bonds was going to get tougher. In the past year they added to higher-quality and ‘investment grade’ bonds. They’ve also increased the level of cash and reduced investments in higher-risk higher-yielding bonds.
Their predictions haven’t been proved right though, as bond markets have generally continued to rise. We like the fact the managers are prepared to be flexible with this fund and think it has the potential to do well over the long term, though there are no guarantees. It doesn't currently feature on the Wealth 50 as we prefer other funds run by the bond team at Invesco. The managers have the flexibility to use derivatives which adds risk.
Corporate Bond. Investment grade corporate bonds are mainly held in this fund. Richard Woolnough combines his views on the wider economy with research on sectors and companies to identify what he thinks are the best opportunities in the current environment.
The fund has performed broadly in line with the average fund in the Corporate Bond sector over the past year. The manager has kept its ‘duration’ relatively short. This provides some shelter if interest rates rise, because the prices of short-duration bonds don’t fall as much as long-duration bonds when interest rates rise, or are expected to rise. In recent years interest rates have stayed lower for longer than expected. So long-dated bonds have delivered stronger returns and it’s been the wrong call to be short duration.
Woolnough has an impressive longer-term track record, though past performance isn't a guide to future returns. The fund isn't currently on the Wealth 50. There are other managers investing in corporate bonds we rate at least as highly, but with lower charges. Please note the manager has the flexibility to invest in high yield bonds and use derivatives, which increases risk.
Strategic Bond. Eric Holt and his team focus on undervalued and overlooked areas of the fixed-interest markets. This includes bonds without a credit rating or those with a claim on assets, such as property or cash flows.
The manager currently finds the most opportunities for income in higher-risk, higher yield areas of the bond market. On the other hand he's avoided areas where he doesn't think there's enough value or income on offer, including those that are perceived to be safer, like UK government bonds.
We view this fund as a more adventurous way to invest in bonds because high yields are typically offered by companies that are less financially secure. As a result, the fund's unlikely to offer shelter in an economic or bond market downturn, and we expect it to be more volatile than most others in the Strategic Bond sector.
Please note as this is an offshore fund you are not normally entitled to compensation through the UK Financial Services Compensation Scheme.
Corporate Bond. The manager mainly focuses on investment-grade corporate bonds. He's prepared to seek opportunities off the beaten track and invest in bonds overlooked by other investors to aim to generate an attractive income.
We like Jonathan Platt's investment approach. Along with his experienced bond team, they rigorously analyse bonds that many other investors overlook. It's helped drive long-term returns, though it means taking on a bit more risk than some other corporate bond fund managers. Some of these bonds are unrated. It means they don't pay to get a rating from a credit agency, but the team are comfortable investing in these bonds if they think they're high enough quality, based on their own research, and they pay an attractive income. The fund also currently has investments in banking and insurance bonds. This includes bonds issued by HSBC, Lloyds and AXA. It can also invest in some high yield bonds, which increases risk.
Strategic Bond. This is a very flexible bond fund managed by two experienced fund managers. They aim to provide some shelter to your investment when they see tough times ahead, and stronger returns when the outlook is better.
The managers have invested this fund in a way that means it could hold up relatively well if bond markets run into trouble. They currently hold plenty of cash and bonds that can be sold quickly, for example. It also means they can invest in other areas of the market that could provide a stronger return when market conditions look better. The rest of the fund is focused on areas such as financial corporate bonds. The managers think banks are in a much stronger position since the 2008 financial crisis.
This cautious approach has held back performance in recent years because bonds markets have generally performed well. But we think it could provide some shelter when markets are weaker. Please note the fund can invest in high-yield bonds and derivatives, which increase risk.
Global Bond. Jim Leaviss has lots of flexibility with this fund. He invests across global bond markets and currencies. The fund isn’t focused on providing a high income like some other bond funds, but it offers useful diversification to a UK-focused bond portfolio.
Jim Leaviss uses the full flexibility afforded to him in running a Global Bond fund and proactively adjusts the portfolio in response to changing economic conditions. He's one of few fund managers who has done this successfully on a global basis, and we think he has the experience and resources to do an excellent job for long-term investors.
The fund retains significant exposure to overseas currencies. The US dollar represents almost one third of the fund, while the euro and Japanese yen are also prominent. We expect investors to benefit if sterling weakens against these currencies, though the reverse is also true. We think the fund could be useful in diversifying a UK-focused portfolio.
This fund can invest in emerging market bonds and derivatives, which both increase risk. The fund may invest more than 35% in securities issued or guaranteed by a member state of the European Economic Area or other countries listed in the fund’s Prospectus.
Government Bond. This fund aims to track the performance of the FTSE Actuaries UK Conventional Gilts All Stocks Index. This is made up of a range of UK government bonds that are due to be repaid to bondholders over the short, medium and long-term.
The fund provides investors with a low-cost way to gain broad exposure to the UK government bond market. This area of the market provided a positive return over the past year, though this is not a guide to how the index or fund will perform in future. Charges for this fund can be taken from the capital rather than the income created which can increase the yield but reduce the potential for capital growth.
Latest research updates
Please note the research updates are not personal recommendations to trade. If you are unsure of the suitability of an investment for your circumstances please seek advice. Remember all investments can fall as well as rise in value so investors could get back less than they invest.
Our expert research team provide regular updates on a wide range of funds.