Bonds and Fixed Income sector investment review

What are bonds and fixed income?

Fixed income investments, also known as bonds, represent the debt of companies, governments or other institutions. They typically pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of a specified term. It’s an asset class that attracts investors looking to take some risk with their capital in exchange for the prospect of a higher longer-term return than cash.

Income potential varies according to the issuer of the debt. More risky companies – or countries – have to pay a higher coupon to attract investors, while low risk entities can issue lower yielding debt, perhaps more in line with general inflation or interest rate expectations, reflecting the minimal risk of default (the non-payment of income or capital).

A bond’s ‘yield’ is the measure of a bond’s income and is a percentage calculated by dividing the annual income payable by the price. For instance, a bond worth 100p that pays 6p a year has a yield of 6%. You should not confuse this with interest rates payable on cash because a bond can fall in value and capital (and income) is not guaranteed.

Most fixed income investments are considered lower risk than equities but have lower potential upside and don’t usually provide an income that grows – hence the name. However, their lower volatility and ability to provide a consistent income can make them attractive to balance an income portfolio, and more cautious investors may even decide to have a higher weighting to bonds than equities. Over long periods bonds and equities do not tend to move in tandem, though over shorter periods they can.

What are the options for investing in bonds?

Funds investing in this asset class have a wide variety of different strategies and areas of focus including:

• Government bonds – represents the debts of nations such as UK gilts or UK treasuries. As these governments are most unlikely to renege on their debt these funds are usually considered very low risk from a credit perspective but do carry a higher level of sensitivity to inflation and interest rates, which means they can experience considerable ups and downs in value if expectations change. Government bonds of less developed countries represent a riskier proposition from the perspective of creditworthiness, and some modern era examples of default include Argentina and Venezuela.

• Corporate Bonds – Funds investing primarily in the debt of companies, which generally offer a higher yield than government debt. Provided a company’s credit rating is high enough its debt will be referred to as ‘investment grade’.

• High Yield Bonds – This area focuses on higher yielding but higher risk company bonds or other riskier areas. They generally pay more income, sometimes considerably more, but there is more risk of default (non-payment of income or capital) than other with higher quality debt.

• Some funds including Strategic or Global bond funds span a combination of these areas, with the former predominantly UK-focused and the latter global. You should check a fund’s literature, including Key Information Document and prospectus, to understand the objectives, scope and risk of a fund before investing.

Investors can also choose between active or passive funds for their fixed interest exposure. Active funds employ managers to try and select the best performing investments, whereas passive investments such as trackers, or many exchange traded funds (ETFs), simply aim to replicate the performance of an index. The passive constituents on our Preferred Fundlist offer simple exposure to either UK gilts or UK corporate bonds to provide straightforward building blocks for portfolios and come with low charges.

How have bonds performed recently?

There is general agreement in markets that interest rates in the US, the Euro-area and the UK will continue to be cut, albeit at a measured pace. This provides a decent backdrop for bonds following a difficult time in the post-Covid environment of higher inflation and interest rates.

Higher interest rates have a negative impact on bonds as they typically pay a fixed amount of income that must remain competitive with higher rates on cash. Thus prices fall (and yields rise) when investors expect a more inflationary and higher interest rate environment, and the reverse when they think pressures are easing.

Following a sharp sell-off over the course of 2022 and early 2023, bonds have had some better periods since but have ultimately not delivered strong returns thanks to inflation remaining stickier than many supposed. However, given the significantly higher yields now available, the market is priced more realistically for the risks of an ongoing higher inflation and interest rate environment. As an asset class that we think offers significant opportunities as well as benefits of diversification.

Government bonds have underperformed compared to corporate bonds and high yield over the past year because they are driven overwhelmingly by interest rate sensitivity and provide no extra yield for credit risk. There are also worries surrounding the large amount of government bonds being issued, both here and in the US, which has weighed on the market at times. Investors in company debt, meanwhile, have faced the same turbulence but have been assisted by a higher income return and a low level of defaults.

In particular, for those envisaging a scenario of rates being cut sooner and faster, perhaps in the event that central banks misjudge interest rate hikes and cause a more difficult economic environment, bonds offer an appealing prospect. It’s tempting to park money in cash right now, but when an investor buys a bond, the return is locked in for the whole term so long as the borrower remain creditworthy. If this is, say, 5%, they can be assured that’s what they will receive each year until the capital is paid back (known as ‘redemption’). With a savings account, the bank may change the rate at any time, which they will if interest rates fall, however unlike a bond capital is guaranteed.

Here's how the actively-managed funds in the Fixed Income sector on our Preferred List got on over the past year, as well as in previous periods, with commentary on each fund detailed below, although please note that past performance is not a reliable indicator of future returns.

Performance of Fixed Income funds and their respective sectors on the CSD Preferred List

Past performance is not a reliable indicator of future returns. Figures are calculated in £ on a % total return, bid to bid price basis with net income reinvested; Source: FE Analytics, data to 30/11/24.

Fixed income investments to consider

1. Janus Henderson Strategic Bond

Managers Jenna Barnard and Nicholas Ware aim to add value in bond markets by taking strategic asset allocation decisions between countries, asset classes, sectors and credit ratings. The flexibility of the mandate, as well as the depth of resource and the experience of the team, affords them the chance to perform strongly irrespective of the prevailing market conditions. However, the past few years have been tough for the fund as the managers were too early in their call that inflation and interest rates would subside.

The portfolio is positioned in line with the team’s view that the global economy will experience a ‘hard landing’. This has led to a sizable allocation to government bonds and high-grade corporate debt where there is less risk of default, and the primary driver of returns is interest rate sensitivity. From a more tactical perspective, a 9.5% allocation in asset or mortgage-backed securities was added at the end of 2023 when the asset class sold off. This has now been pared back to around 5%.

Investors may wish to consider this fund if they agree with the managers’ prognosis of a more rapid fall in inflation and interest rates, or as diversification from funds that would benefit from a rosier economic scenario. The approach currently is focussed on longer duration government bonds and shorter dated corporate debt. This is likely to be resilient in more adverse market conditions where growth is low, and interest rates cuts are more rapid that widely assumed.

2. Rathbone Ethical Bond Fund

This corporate bond fund has been managed since 2004 by Bryn Jones. He aims to build a portfolio of good quality investment sterling denominated grade bonds (avoiding the riskiest ‘high yield’ bonds) while applying a broad range of both positive and negative social, environmental and governance (ESG) screening criteria that could appeal to those with ethical priorities.

The fund is typically focussed at the more adventurous end of investment grade bonds, investing with a skew towards the higher yield end part of the market and a bias to banks and insurers. It has tended to offer a yield premium over other funds in its sector as a result.

The fund was well positioned in the review period, taking advantage of tightening credit spreads. Interest rate sensitivity was limited by skewing the fund towards shorter dated bonds, which assisted performance. However, the managers moved to a more neutral stance in the autumn of this year mainly through longer dated green gilts.

The fund’s ethical aims are achieved via a combination of screening out unacceptable business practices, and lending money to companies or organisations that have a tangible positive impact on society or the environment. One recent example is an Amazon Reforestation-Linked Outcome Bond issued by The World Bank.

3. Vanguard Global Credit Bond

This actively managed fund employs a highly risk-controlled approach to investing globally in mainly investment grade corporate bonds. There is some limited scope to invest in high yield and higher quality emerging market bonds. Although best known for its passive strategies, the US fund group is also one of the largest active fixed income managers in the world and is resourced accordingly. We believe a deep and experienced team is essential for this type of approach, which is hunting for the most compelling ideas across a very large universe.

It was a characteristic year of steady outperformance for the fund, although past performance should not be taken as a guide to the future. The managers do not take large bets in terms of geography or interest-rate sensitivity, instead seeking gradual outperformance through individual bond selection. This does mean it can carry a higher level of interest rate sensitivity and risk, though.

Stock selection in Europe and emerging markets has been accretive over the past year with value also added in the real estate sector. A small sleeve of emerging market sovereign debt was also a steady contributor, including a successful trade in Saudi Arabian debt bought at the start of the year and sold in April.

We see this fund as a possible building block for investors who prefer straightforward exposure to the asset class, rather than a strategic, flexible or global bond manager that aims to move around the fixed interest spectrum more aggressively in search of outperformance. Value should be added (or subtracted) on a more incremental basis. It’s also a compelling alternative to the narrower and generally more expensive funds in the Sterling Corporate Bond sector.

4. Wellington Global High Yield Bond

High yield bond funds can sometimes be useful to bring something different to a portfolio. For instance, as well as providing a higher yield than safer, investment grade bonds, they react differently to changing economic circumstances. They are more likely to be resilient in a strong economic environment where company bankruptcies are falling, whereas the threat of higher inflation and interest rates in these circumstances may have a greater negative effect on government bonds and other bonds with lower yields.

High yield debt is a complex asset class where thorough research combined with prudent risk management can add significant value. There can be lots of pitfalls with the biggest components of indices often the companies with the largest amount of debt rather than any other determinant of size. We therefore generally prefer an active approach as opposed to a passive strategy of ‘buying the market’.

This fund offers straightforward and diversified high yield exposure, and the team are presently adopting a moderately defensive stance in comparison the broader market. Although they expect a fairly benign economic scenario of slowing growth, they expect a deterioration in corporate earnings in the coming quarters as the economy loses momentum. They therefore favour more resilient businesses with recurring cash flows that exhibit advantages over competitors. Conversely, the managers are cautious on sectors experiencing high capacity including the automotive, AI-related technology and renewable sectors.