Forecasters have called the top of the bond market on numerous occasions over the last two years. However, gilts have resolutely not behaved the way many bond fund managers had expected. Today, ten year gilts are yielding 1.9 per cent. Yields may have touched a low of 1.4 per cent last summer, but in reality they have settled in a tight trading range.
Those who have shorted gilts in anticipation prices will eventually fall have thus far suffered the consequences. Betting against central banks is seldom a good policy; as liquidity has continued to be pumped into the markets via quantitative easing, gilt prices have remained stubbornly high.
By historic standards, bonds are expensive. It is not inconceivable to imagine prices to remain elevated for some time yet. We are living in a very different world, for the time being at least, where a continuation of ultra-low interest rates are forcing investors to hunt for yield in all sorts of asset classes.
An extension of the Bank of England’s Funding for Lending Scheme means banks don’t require our deposits, driving interest rates lower with every likelihood they could fall further. Against this backdrop, it is not surprising gilts have not seen a dramatic yield rise.
Aside from gilts, all areas of fixed interest are being chased after. This includes more risky high yield bonds, which too have been touching on levels not seen historically.
This does not mean value can no longer be unearthed in this area of the market but care does need to be taken. It is for this reason I prefer to invest with an experienced bond manager to make the decisions for me.
Eric Holt, manager of the Royal London Sterling Extra Yield Bond fund, acknowledges the dangers but is still finding plenty of opportunity.
While Holt views the gilt market as expensive, he does not expect its direction to change any time soon, believing there is potential for further QE in the future. In an environment of low growth, low interest rates, and relatively low inflation, this is exactly the type of environment that bonds could do well in.
At present, Holt’s fund has 42 per cent invested in high yield bonds, with a further 35 per cent in unrated bonds. Unrated bonds are issued by companies who haven’t paid an agency for a credit rating; Holt prefers to do his own research into a company’s strength rather than relying on ratings agencies.
Many of those held in the portfolio are collateralised bonds, secured against the assets of the company issuing them. Being unrated, these bonds also tend to offer a better rate of interest.
The Royal London Sterling Extra Yield Bond fund currently offers a running yield of 6.15 per cent and dividends are paid quarterly.
This fund should not be considered low risk simply because it has the word ‘bond’ in it – a common misconception. Indeed, the fund was severely hit, at least in terms of its capital value, during the credit crisis in 2008. Holt, however, held his nerve and fund has since doubled in value.
He has recently purchased seven year mortgage debentures issued by Alpha Plus Holdings plc, yielding an attractive 5.75 per cent. The bond is secured on property, in this case London private schools.
He has also purchased bonds issued by Annington Finance, which are secured on MOD accommodation.
Holt recognises liquidity for these bonds is low but at a yield of 10 per cent, he feels he is being appropriately compensated for the risk taken.
The best bond returns are likely to be behind us but Holt is confident he can deliver attractive total returns from a combination of both income and capital growth.
A large part of my own Sipp is invested in this fund. In my opinion, interest rates are unlikely to rise anytime soon. As the search for yield continues to gather momentum, I am happy to hold this fund until the facts change.
Mark Dampier is head of research at Hargreaves Lansdown