Fixed income funds for a new era of interest rates

The Bank of England finally bit the bullet on interest rates at the start of August. The Federal Reserve looks set to cut in September, while the European Central Bank was first out of the blocks in June. The cuts so far have been small, but often it is the direction of travel that is more important than the magnitude of the cut.

Lower rates usually boost government bond prices. This is good news for existing investors in bonds, who will see the capital value of their holding rise. However, it’s not so good news for new investors, who will have to make do with a lower yield.

There are caveats to this: the impact of rate cuts on bond markets will depend how much has already been anticipated by markets. For example, in the UK, the 10 year bond yield didn’t fall by the full 0.25% in response to the rate cut because some measure of easing had already been expected. Equally, rates may fall further, which would push bond prices still higher (and yields lower) in future. However, it does mean that new investors in fixed income may not be able to achieve as high an income.

For corporate bonds, it matters why interest rates are dropping. If rates are dropping because central bankers fear a recession, that’s tricky for corporate bonds. It could increase levels of corporate distress and, therefore, defaults. Spreads widened out in late July/early August, but have come back down as recession fears have eased. They are now back at multi-year lows. This means there is less wiggle-room for investors if the economic environment worsens.

While the environment for fixed income is considerably better than it was for much of the 2010s, it is perhaps more difficult than it was at the start of this year. The all-in income yield for bonds is still appealing, but it is worth being discerning about where to invest.

Flows into EMEA fixed income ETFs were the strongest on record in July, attracting $10.7 billion*, but our view is that this is a precarious moment to be investing in passive fixed income options. We favour highly active funds that can cherry-pick opportunities in this environment.

The attraction of high yield

High yield has been a step too far for many, with investors worried that they are not sufficiently compensated for the risks in the sector. High yield spreads over government bonds remain low relative to history and do not appear to reflect any risk of a more difficult period for the global economy.

However, Mike Scott on the Man GLG High Yield Opportunities fund continues to make hay in a tough sector. His approach is different to many of his peers. He believes other high yield investors pay too much attention to ratings and therefore miss idiosyncratic opportunities. Equally, they tend to prioritise index heavyweights, which are often the companies with the highest debt. There are 1,500 names in the high yield universe and he takes the broadest possible view.

He is still finding opportunities: “Whether growth can remain stable is a key question, along with inflation and whether the Fed can begin to normalise interest rates. High yield spreads in the US remain relatively tight, yet we still see room for tightening in Pan Europe and have positioned the fund accordingly. On a sector basis, we expect non-cyclicals and more defensive aspects of the market to outperform as the year goes on.”

Mark Benbow, co-manager of the Aegon High Yield Bond fund, explains the evolving high yield bond market on a recent episode of the Investing on the go podcast. He specifically discusses how these bonds can play a vital role in a diversified portfolio.

Research all high yield bond funds

The appeal of strategic bonds

Managed by Dickie Hodges, the Nomura Global Dynamic Bond fund is a ‘go anywhere’ fund focused on absolute returns. He can invest in the entire range of bond sectors including government bonds, corporate bonds, emerging market bonds and inflation-linked bonds, and can use derivatives to help manage risk and exposure. It is a flexible approach, and incorporates an analysis of the global economy and the sectors and investment themes that look most attractive, with fundamental analysis, to generate strong idiosyncratic ideas.

At the moment, Dickie expects inflation to continue to subside and for the Fed to gradually cut interest rates. He adds: “We believe that these rate cuts will lead to a positive environment for a wide range of risk assets, and we have positions in emerging markets, convertibles and European financials that will benefit from the realisation of that environment.” However, he admits there is a short-term risk of potential volatility in bond yields as a result of political uncertainty and has hedged some of the risk**.

The fund should be able to take advantage of investment opportunities across the breadth of bond markets and can adapt to different environments. That makes it a sound option for today’s volatile fixed income markets.

Led by Stuart Edwards and Julien Eberhardt the Invesco Tactical Bond fund fund uses an active style, continually adjusting risk according to market conditions, and the fund has the flexibility to invest across the entire fixed-income spectrum. This is a truly differentiated approach to most strategic bond funds and benefits from investing in a very wide opportunity set.

The team believe investment grade bond yields remain attractive despite tight spreads and “it’s still a bond-friendly backdrop and a good time to hold high-quality fixed income assets. From a credit perspective, bond market yields remain attractive in our view despite tight spreads. Although new issue premiums are modest, we are still finding selective opportunities in the primary market.”

Research all strategic bond funds

*Source: Bloomberg, August 2024

**Source: Nomura Market View, Dickie’s View August 2024