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Last week’s sharp movement in Italian government bond yields was a timely reminder that it’s not only equities that can be volatile and risky, bonds can be too: political shenanigans in Italy during the month of May spooked investors, causing its stock market to fall around 9%*, while the 10-year Italian government bond yield rose from 1.8% to just over 3%**.
That doesn’t sound like a lot but just a small rise in yields can lead to larger price falls when it comes to fixed income. Indeed, the Italian 10-year government bond index also fell by 9%* over the calendar month.
Because interest rates in the developed world have been so low for so long, the turning point – when central banks start to raise interest rates – has been a worry in fixed income for some time. This is because a higher base rate means bond yields will rise too. So navigating this type of changing environment successfully, will be key to returns in this asset class in the near future.
But that doesn’t mean you have to avoid bonds – after all, they work well as a portfolio diversifier and can be a good source of income. We take a look at four different strategies used by Elite rated managers to minimise this risk and make the most of the opportunities the asset class still has to offer.
Asset-backed securities, called ABS, are bonds backed by financial assets. As floating-rate bonds, they offer coupons (yields) that will rise in line with interest rates and, a supportive economic environment reduces the default risk in the underlying securities. One fund that uses these to good effect is TwentyFour Dynamic Bond. It is managed with an emphasis on credit risk to ensure protection of investors’ capital and income wherever possible and its consistent weighting to ABS (currently just over 13%***) differentiates the fund from many of its peers.
‘Duration’ is the length of time until a bond matures. The longer the duration, the more susceptible a fixed-rate bond is to interest rates risk. If it has a yield of 2%, which it will pay for 10 years, but interest rates rise to 3%, why would you invest in the bond when you could make more money in a bank account? One way of avoiding this issue is to invest in ‘short-dated’ bonds. As interest rates rise, you can use the money from maturing bonds, to buy new ones with higher yields. AXA Sterling Credit Short Duration Bond invests in high quality corporate bonds with expected maturities of less than five years.
Floating rate notes pay a variable—or floating—coupon rate. They can be issued by governments or corporations, so it’s worth keeping in mind that even though they are thought of as a conservative investment, there is the risk the company may not be able to re-pay your capital at the end of the floating rate note’s term. Floating rate notes also tend to have shorter dates to maturity than bonds. For example, a floating rate note may be issued for three months, six months or a year. One fund that has used floating rate notes a lot in recent times is Church House Tenax Absolute Return Strategies. It currently has a 34%*** weighting to the asset class.
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 – the risk that the company will default and not pay back the original loan. Aviva Investors High Yield Bond has an extremely low to non-existent default rate, which is a testament to the manager’s stock picking. This fund not only has an attractively high yield of 4.7%*** but the manager has also kept average duration low (4 years) and also invests in some asset backed securities.
*Source: FE Analytics total returns in sterling, 1 May to 31 May 2018 using MSCI Italy and Citi Italian Government Bond 10+ years indices.
***Source: Fund fact sheets, 30 April 2018