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The funds that should protect you from rising interest rates

14 August 2015

Abstract: FE Trustnet highlights two top-rated high yield bond funds which may be of interest to investors who are worried about a rising interest rate environment.

By Joshua Ausden,

Head of FE Trustnet Content

Many commentators are expecting a widespread sell-off when interest rates inevitably rise in the US and UK, but experts and history tell us that one area is likely to weather the storm.

IA Sterling High Yield has been one of the best performing sectors since the financial crisis, more than doubling investors’ money since March 2009 with significantly less volatility and downside risk than UK equities.

Performance of sectors and index since March 2009

 

Source: FE Analytics

Returns have been lacklustre for the past year, and investors would be forgiven for thinking rising interest rates would provide a further headwind to the asset class.

On the contrary, history tells us that when interest rates rise high yield bonds actually perform rather well. According to research from JP Morgan, in the 15 years that Treasury yields have increased since 1980, high yield bonds have posted an average return of almost 14 per cent. This compares to an average return of 4.5 per cent for investment grade bonds over the same period.

High yield bonds are influenced more by credit quality than changes in short and long-term interest rates. As rate rises tend to occur during times of economic strength, which is generally a plus for corporate credit, the net impact for high yield bonds is positive – even if yields do rise slightly. Rate rises are a greater enemy to areas of the bond market with a longer duration such as investment grade debt.

Michael Scott (pictured), manager of the Schroder Monthly High Income fund, agrees that high yield bonds are likely to perform well as interest rates rise – especially if as expected they increase gradually.

“The Federal Reserve will only raise rates if they assess that the economy is on an improving trajectory,” he said.

“High yield, as it has done in past hiking cycles, should deliver positive total returns as the high coupons and carry of the asset class are able to offset the rise in underlying yields. Furthermore it is likely that in this rate hiking cycle the Fed will only raise rates gradually.”

In spite of the strong performance of high yield in recent years, the IA Sterling High Yield and IA Global Bonds sectors still present investors with some attractive starting yields. According to FE data, 30 funds across the sector are currently yielding over 4 per cent, with half of these yielding more than 5 per cent.

All isn’t rosy in high yield, of course. There remain overvalued areas of the market offering very little in the way of yield compared to their history, and low oil prices and increased potential for defaults as a result are seeing many experts avoid the US high yield market, which has a significant weighting to energy companies.


 

However, as long as rates do indeed rise gradually (a spike will most likely result in a sell-off in all areas of the bond and equity markets) high yield bonds could be a useful addition to investors’ portfolios.

Here are two top-rated options that may be of interest:

 

Kames High Yield Bond

The £1.5bn portfolio, managed by Philip Milburn and Claire McGuckin, is the only one in the IA Sterling High Yield sector that makes it into Rob Gleeson and the FE Research team’s FE Select 100 list.

The managers invest on a global basis, but use derivatives to remove currency risk. North America dominates the regional allocation at 52 per cent, though they have little in the energy sector. Europe and the UK have a combined weighting of 30 per cent.

Milburn and McGuckin place a keen emphasis on protecting against the downside. While they look for debt which is cheaper than it should be, they create models of the companies and stress-test them for sensitivity to different events. They also use the insights of Kames’ interest rate and credit risk specialists, who consider broader economic factors.

Performance has been strong since the managers took over; FE data shows Kames High Yield Bond has returned 119.66 per cent since November 2003, beating the sector average by around 20 percentage points. The fund is also ahead over a five and 10 year period, though a weak period of performance in 2012 and 2013 as a result of its high US exposure means it’s slightly lagging over three years.

Performance of fund and sector since November 2003

 

Source: FE Analytics

The managers acknowledge that there is a risk that rates rise more quickly than investors expect, and have a bias towards easily tradable bonds to minimise the effect of any mass outflows as a result.

Kames High Yield Bond is yielding just over 4 per cent and has ongoing charges of 0.79 per cent.

 


 

Baillie Gifford High Yield Bond

Square Mile, the investment consultancy and research firm, are a big fan of the £762m Baillie Gifford High Yield Bond fund, giving it an A-rating.

The fund has been headed up by Donald Phillips and Robert Baltzer since June 2010, and delivered top quartile returns of over 46 per cent since then.

Performance of fund and sector since June 2010

 

Source: FE Analytics

The fund has much of a focus on the UK and Europe than its Kames rival, allocating 38 and 31 per cent, respectively.

“Through their analysis the team identify bonds which are trading below their fair fundamental valuations, and which have an identifiable catalyst that will trigger a market revaluation,” said Square Mile.

“They will only invest in bonds where they have a high conviction that such a catalyst exists, and this results in a relatively concentrated portfolio of around 50 to 70 stocks.”

“Position sizes usually vary from 1 to 3.5 per cent, but in exceptional circumstances can be up to 5 per cent, depending on the size of the mis¬valuation, the relative risk of the bond, the conviction which the team have in the catalyst occurring and the correlation of the position to other positions in the portfolio.”

Phillips and Baltzer’s largest weighting is currently a 3.2 per cent position in packaging company Ardagh Group, which has a 4.25 per cent coupon.

“The team are experienced and stable, with very little turnover. We have confidence that the managers will continue to follow this process and to generate a high level of income,” Square Mile added.

Baillie Gifford High Yield Bond is yielding 3.8 per cent and has ongoing charges of 1.03 per cent, though can be bought for as cheap as 0.38 per cent on certain platforms.  

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.