What role does fixed income play in portfolios today?

Bonds have been back in business in 2023 as investors can once again look to get an attractive yield and some diversification benefits from the asset class. It’s a far cry from the pain of 2022, which ended up being the most challenging bond market in four decades*.

Things started to change at the back end of last year as central banks looked to react to soaring inflation by raising interest rates – which improves the income bonds offer. We’ve also seen central banks attempt to disincentivise risky investment and slow markets down, making safer assets more attractive; all of which has made bonds a more compelling proposition

Take corporate bonds as an example. The yield on a corporate bond fund is made up of two parts – the risk-free rate (i.e. gilts) and the spread (the difference in yield between the corporate bond yield and the risk-free rate on government bonds). Spreads are historically attractive on fixed income at their current levels. The two-year gilt stands at just over 4.5%**, so investors should be looking for around 6.5% from a UK corporate bond (2% above the risk-free rate). That’s not to be sniffed at when there is so much uncertainty in markets.

Given this backdrop, it is a surprise to see the asset class experienced outflows of £356m during August 2023***,  the first monthly retrenchment since October the previous year***. The question is whether this is just a seasonal slowdown or whether signs of inflation peaking have started to put investors off the asset class.

Here we take a look at the pros and cons of investing in this area, which funds are worth a look, and how the managers are currently running their portfolios.

Types of fixed income

There are plenty of fixed income funds. Some invest in government debt, while others focus on buying bonds issued by companies. This means the risks taken by different portfolios will vary. Alongside portfolios that provide a steady income are racier products looking for higher rewards. 

Broadly speaking, many bond funds are popular during financially challenging periods as people are looking to earn an income, without risking too much on the equity markets.

Government bond yield support

We have spoken to a number of fixed income fund managers in recent weeks to ask them why investors should consider putting their faith in this area.

Stuart Edwards, manager of the Invesco Tactical Bond, predicts a situation where economic growth starts to deteriorate due to the lagged impact of monetary tightening. “I describe it as a transition year between inflation risks and growth risks,” he told us in a recent podcast interview. “It’s not necessarily obvious that you want to be really loading up on risk or be really defensive.” 

While acknowledging valuations are a lot better than 18 months ago, Stuart is now focused on finding pockets of value, while also thinking about the big picture.

“I’m reasonably downbeat on the economic environment heading towards the end of this year and into 2024,” he added. “So, ultimately, that should support some government bond yields in the UK.”

Is a recession looming?

Mike Riddell, the manager of the Allianz Strategic Bond, has held the view that we are headed for a recession – something that isn’t being priced into markets.

“We don’t know exactly when it will happen and that’s been our view for 12 months,” he said. 

“Globally we’ve had the most aggressive interest rate hikes we’ve ever seen.” What investors don’t appreciate, he pointed out, is that it takes at least a year for an interest rate hike or cut to have any impact on the economy. This means that he expects all the interest rate hikes we’ve endured to eventually cause a slowdown.

“This is why we expect a recession,” he added. “When we look at what markets are pricing in – any market that you like – they’re simply not pricing in that risk of recession.”

Getting the balance right

Meanwhile, Rathbone Ethical Bond managers Bryn Jones and Stuart Chilvers believe selected higher quality corporate bonds offer attractive yields, without taking on too much risk. They have adopted a balanced approach on the fund.

“We’re pairing our credit exposure with longer-dated government bonds via a barbell structure,” they explained in a recent fund update****. “In bond investing, a barbell combines significant weightings of short-dated bonds with significant weightings of much longer-dated ones.”

The managers said one end of their barbell tilts towards shorter-dated credit, which is less sensitive to interest rate moves. The other end, meanwhile, tilts towards longer-duration government bonds that usually outperform in a slowing-growth, falling-rate environment, in which some corporate bonds could struggle. 

“We think this tilt could give us a nice cushion against any volatility in credit markets if it looks like we’re heading towards a harder economic landing and central banks are gearing up for rate cuts,” they added.

Other funds worth considering

Artemis Target Return Bond

We class Artemis Target Return Bond as a ‘Steady Eddie’ fund that targets an absolute return, with a particular emphasis on controlling risk. The aim is to deliver an annual return of at least 2.5% above the Bank of England base rate, after fees, on an annualised basis over rolling three year periods.

Veteran manager, Stephen Snowden, invests in a mix of government and corporate bonds, as well as asset-backed securities and mortgage-backed securities. We believe this is an excellent choice of fund for those who are more risk averse, but crave a better return than cash, along with the confidence of a skilled manager at the helm.

Premier Miton Strategic Monthly Income Bond

This fund was launched in September 2020 and targets a steady monthly income, while minimising volatility and providing a better risk-adjusted income compared to both bond funds and equity income options. The fund is benchmark agnostic and tends to have a lower duration than the market.

This fund is highly active, with turnover of 300-500% each year since its inception.

The fund currently has only 14% in high yield due to concerns about refinancing at higher rates in this segment of the market. By contrast the fund has greater exposure in A-rated (24.8%) and BBB-rated bonds (39.8%)^.

Co-manager Lloyd Harris says: “We are getting 7-8% returns in relatively safe assets. We’re also very active, targeting alpha generation through lots and lots of small returns of alpha, generated about 200 basis points on top of the yield over time. Add the two together and investors are getting equity like returns from safer parts of the market.^^”

*Source: ishares, Why this may be the most attractive bond market in 15 years, April 2023

**Source: MarketWatch, October 2023

***Source: Investment Association 

****Source: fund commentary, August 2023

^Source: fund factsheet, August 2023

^^Source: Premier Miton, October 2023