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The best opportunities in the bond market – and the higher yielding funds to play them

15 September 2016

Whitechurch says that fixed income yields will continue to remain low for some time to come, despite concerns that they offer very little value for investors going forward.

By Alex Paget,

News Editor, FE Trustnet

Fixed income investors have had a stellar time of it so far this year – continuing a theme that has caught out many an investor since early 2014.

Yields on core developed market bonds have fallen to new lows in 2016 with the likes of a 10 year gilt now yielding 0.9 per cent (constituting a 54 per cent drop year-to-date), meaning that returns have been high across the fixed income spectrum.

According to FE Analytics, for example, the IA Sterling High Yield sector has returned 7.56 per cent, the IA Sterling Corporate Bond sector has returned 10.44 per cent and the IA UK Gilts sector has returned 14.28 per cent over that time.

Performance of sectors in 2016

 

Source: FE Analytics

There have been numerous drivers behind this trend, despite the fact that many investors have been positioning for a gradual increase in bond yields. Firstly, government bond yields spiked at the start of the year thanks to a general flight to safety after China’s woes persisted and there were concerns that central powers were running out of fire power.

Since then, the shock result during the EU referendum caused yet another rally for defensive areas of financial markets. More recently, though, the team at Whitechurch says there are two factors in particular which have caused a yields to plummet.

“First, the Bank of England cut the base interest rate by 0.25 per cent in response to any potential Brexit repercussions for the UK economy,” Whitechurch said.

“This saw UK gilt yields compressed further with long-duration index linked gilts delivering over 11 per cent during the month, as yield curves flattened further. As well as reducing UK interest rates, the Bank of England also announced further monetary stimuli, with an additional purchase of £60bn of gilts and £10bn non-financial corporate bond purchase programme.”

“The final details of what corporate bonds will be bought are yet to be announced but it will not be from the primary market, as bonds will have to have been in issue for at least one month.”

The second focal point, according to Whitechurch, was the recent US Economic Symposium at Jackson Hole during which US Federal Reserve chair Janet Yellen presented.

“Janet Yellen softly intimated that the potential for further US interest rates hikes was back on the agenda. However, the lower than estimated non-farm payroll figures released at the beginning of September effectively ruled out such a move, bolstering markets.”

Many believe the central bank will continue with its rate hike cycle towards the end of the year, however, which would ultimately put pressure on bond yields.


As such, many view fixed income has massively overvalued and an asset class that is all but certain to lose investors’ money going forward.

Performance of indices over 3yrs

 

Source: FE Analytics

While there seems to be logic to that argument given the yields on offer, it is a belief that many investors have held over the past three or so years and therefore have (so far) been proven wrong.

Whitechurch says that fixed income still has a role to play within a portfolio and says investors can still afford to reach for yield in the current environment given that central banks around the world will remain accommodative.

“Despite growing speculation of a US rate rise at some point this year, the lower for longer interest rate environment remains and so we don’t see a material increase in bond yields any time soon and we remain unattracted by the lack of yield on offer.”

“We favour corporate debt over government bonds as investment grade corporate bonds offering yields in excess of 3 per cent provide a much more compelling risk/reward profile.”

According to FE data, 46.9 per cent of funds within the IA Sterling Corporate Bond sector currently yield more than 3 per cent while only 8.4 per cent of funds yield more than 4 per cent. That being said, the average yield across the sector is 3.05 per cent.

10 highest yielding sterling corporate bonds

 

Source: FE Analytics

The table above shows the 10 highest yielding funds in the sector at the moment which includes the likes of Alliance Trust Monthly Income Bond (5.78 per cent), Rathbone Ethical Bond (4.6 per cent) and Schroder UK Corporate Bond 4.38 per cent.


One of the largest and most popular, however, is the £5.8bn Invesco Perpetual Corporate Bond fund, which is managed by the experienced Paul Causer, Paul Read and FE Alpha Manager Michael Matthews.

It currently yields 3.78 per cent thanks to its 58.69 per cent weighting to BBB-rated debt and 11.28 per cent to BB bonds.

Invesco Perpetual Corporate Bond has been a strong long-term performer, having beaten the sector average by close to 100 percentage points since its launch in July 1995 with returns of 309.49 per cent.

However, its relative performance has been more subdued over recent times. Indeed, it is bottom quartile over one and three year periods due to the managers’ focus on value.

Performance of fund versus sector over 3yrs

 

Source: FE Analytics

Nevertheless, Square Mile has awarded the fund with its highest AAA rating as the research house believes that while it will go through periods of lacklustre performance relative to the index, it is a core option for those seeking exposure to good quality corporate bonds.

“This fund is run by a highly experienced team of managers, Mr Causer, Read and Matthews, who have proved themselves capable of producing strong returns over longer periods,” Square Mile said.

“Their careful process, and in particular their emphasis on risk, identifies suitable value opportunities which have generated good long term performance for the fund, although investors should note that these can take some time to play out and there can be periods where the fund's performance may differ substantially from that of the benchmark.”

“The managers run this as a relatively high conviction strategy, and are not afraid to express their opinions through the fund's positioning when they see value in the market.”

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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.