How can bond investors navigate a rate rising environment?

In the February 2018 Monetary Policy Committee meeting, Bank of England governor Mark Carney hinted that another interest rate rise could be on the cards soon. With the UK’s economic backdrop remaining steady and inflation peaking at 3% they have two good reasons to consider an increase.

But rising interest rates and above-target inflation are usually bad for bonds. Does this mean that investors should reduce their bond exposure and hold their money elsewhere? Not necessarily, in our view, although it does pay to tread carefully.

First, a bite-sized guide to government versus corporate bonds

The best way to look at the fixed income market is to analyse interest rate risk and credit risk (or the risk that a company will fail to pay their interest) separately. When it comes to government bonds – certainly in developed markets – they of course have very little risk of defaulting. However, this means that their performance almost entirely depends on interest rates.

The longer the duration (or time to maturity) of the bond you hold, the greater the interest rate risk you are taking. After all, if the duration on the bond you hold is 30 years, there is certainly scope for interest rates to fluctuate significantly. Buying into a government bond with a yield of 2% and being forced to hold it when interest rates are 10% would be painful, to say the least.

With corporate bonds, however, it is a slightly different story – even though they are still vulnerable to interest rate rises. Because you are loaning money to a company rather than a government, it means you are susceptible to credit risk as well as interest rate risk, which can either be a positive or a negative.

During periods of significant economic downturns – when we are experiencing a recession, for instance – central banks will push interest rates lower so that consumers and businesses aren’t crippled by high borrowing costs. This means that, while the credit risk of the corporate bond is high, its interest rate risk is much lower. The opposite is the case when the economy is strong.

Options for investors

Given the duration risk I spoke about earlier, investors may wish to consider buying into a fund that only invests in short-duration assets. A good example of this is AXA Sterling Credit Short Duration Bond which, at time of writing, doesn’t have a single holding in its top 10 with a duration above 1.6 years*.

Credit – or corporate bonds – have their place in a portfolio generally, and you can see why if you take a look at the market correction we experienced between the 2 and 8 February this year. As global equities fell, corporate bonds managed to make a small positive return and were less volatile**.

Examples of corporate bond funds we like include Invesco Perpetual Corporate Bond, Royal London Corporate Bond and M&G Corporate Bond.

Another way to minimise interest rate risk while buying into bonds is to look at the high yield sector, as these funds are usually less exposed to rate hikes than their lower-yielding peers. However, investors should note there is no such thing as a free lunch and that the yield serves as compensation for taking on greater risk. Examples of funds that we like in this space include Baillie Gifford High Yield Bond, Schroder High Yield Opportunities and Aviva Investors High Yield Bond.

Finally, another way to minimise interest rate risk is to let the fund managers take the reins and shift their asset class weightings depending on where they see the best opportunities. Strategic bond funds are best suited to this. Not only can the managers decide their asset class weightings, many are also able to use tools such as derivatives to protect on the downside. Here, funds such as Fidelity Strategic Bond and Invesco Perpetual Monthly Income Plus may present themselves as good options.

To sum up, we believe corporate bond are more attractive on a relative basis than government bonds and serve as useful diversifiers as part of a wider portfolio. However, we are cautious on fixed income as an asset class – after all, corporates are still far from immune to interest rate risk. As always, it is better to hedge your bets and hold a variety of asset classes.

*Source: AXA Sterling Credit Short Duration Bond factsheet. Correct as of 29 December 2017.

** Source: FE Analytics. Total return in sterling terms from 2 February to 8 February 2018. Barclays Global Aggregate Credit versus MSCI AC World.