The bond funds to help you navigate a year of rising interest rates

With US inflation hitting 7% last week, and UK inflation reaching 5.4% this week, it seems inevitable interest rate rises are on the cards. In fact, Goldman Sachs and Deutsch Bank are also now suggesting there will be four 0.25% hikes in the US in 2022.

As a consequence, global markets have wobbled. Central banks around the world have a tough job ahead: trying to reverse all the measures they took to keep economies going through the pandemic, without now tipping those same economies into recession.

Both inflation and rising interest rates impact the amount of money consumers have in their pockets. Everything we buy becomes more expensive, as do many mortgage repayments. And while higher interest rates may be welcomed by cash savers, the opposite is true for bond investors.

Why? Because the fixed stream of interest payments on bonds become less valuable as the overall cost of goods and services accelerates. This sends bond yields higher and bond prices lower to compensate.

Gary Kirk, manager of TwentyFour Dynamic Bond fund, explained this relationship between bonds, inflation and interest rates in this podcast:

So, you really need an experienced pair of hands to navigate the bond part of your portfolio through this kind of environment.

Man GLG High Yield Opportunities’ manager Mike Scott, for example, is very experienced and has an excellent track record in navigating the extra risk in the high yield bond sector whilst achieving above average returns. The yield in this area of the market (currently over 5% on this fund) is helpful in the high inflation environment and defaults (when companies can’t pay their debt) are currently low and are predicted to remain so.

Normura Global Dynamic Bond, has another experienced manager at helm in the form of Dickie Hodges. This is more of a total return-type bond fund and uses full flexibility of the fixed income market to invest.

Dickie thinks that inflation will moderate from these levels but will take a long time to do so – that it’s more structurally embedded that people think. He believes rate hikes will be modest, slow and well-flagged, but that there will be volatility because it will happen into a slowing economy and investors will worry.

But this will create opportunities, so he is keeping liquidity high in the fund to be able to invest in new opportunities as they arise. He has some positions in South African and Russian bonds as the high yields more than compensate for the risk, has short-dated high yield bonds but thinks investment grade corporate bonds are very unattractive.

Read more: Five ways bond investors can protect against inflation

Alex Pelteshki, co-manager of Aegon Strategic Bond agrees and says going into 2022 “It is a tricky balance with plenty of room for error, which we believe would also make markets increasingly nervous. Our base case is that the already well flagged withdrawal of monetary stimulus will have a broadly negative impact on fixed income markets. Within that, the volatility of returns will also be higher vs 2021, which should leave plenty of room for alpha generation.”

He also thinks investment grade credit looks tricky and prefers high yield, saying: “total returns and excess returns are likely to be decent for the year, despite some elevated intra – year volatility. These bonds offer a much bigger cushion against rising rates vs the investment grade bond universe and the default risk for most sectors continues to be relatively low due to the broader economic strength.”

“In emerging markets, it will be a groundhog year.” He continues. “We continue to be relatively cautious, with the caveat that valuations have now become more interesting and there will be a time in 2022 when a more meaningful allocation would be warranted. But the current challenges of lower (vs potential) growth due to low vaccination as well as potential hangover from capital flight (US rate hikes) are likely to remain headwinds.”

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