Sector focus: Mind the bond gap

With news media and financial markets dominated by the twin uncertainties of what type of Brexit the Government might achieve and precisely where the new Trump administration could turn their attention next, one growing trend appears to be receiving less coverage than might otherwise be expected. Inflation is on the up in many parts of the world. In Germany and the US it has reached around 2 per cent annualised and, while less here in the UK, it is widely expected to rise further as the weaker pound pushes import prices up.

Higher inflation is not yet a global concern. Some countries are seeing little upward pressure on their cost of living. In the single European currency zone, for example, the inflation rate will have been heavily influenced by the experience of the largest economy as some member nations are seeing little increase in prices.

In contrast, the US is now seeing wage growth running at an effective 4 per cent. This could well pressure the Federal Reserve Bank into more aggressive action. In the UK, the Bank of England will doubtless be keeping a close watch on the inflation level and, in particular, how average incomes fare.

The usual counterbalance for rising inflation is dearer money. Presently, many leading central banks are continuing with the loose monetary policy that was ushered in following the financial crisis of 2008. Some observers are reaching the conclusion that this massive financial experiment may be running out of road. Certainly, it is hard to see how central banks could continue to ignore inflationary pressures if they intensify.

The most obvious casualty of rising interest rates would be bond markets. These benefited hugely from cheaper money as yields were forced down and capital values enhanced as a consequence. There have been wobbles in these markets in recent months as they are still considered a relative safe haven in times of economic uncertainty, and their attraction as an income-producing asset class at a time when cash produces so little will ensure a continuing following.

But if we do see the end of cheap money, can these markets continue relatively unscathed? Perhaps the Sterling Corporate Bond sectors are worth examining as weaker sterling could affect them more directly. Looking at both the Corporate Bond and Strategic Bond sectors, it seems Strategic Bond has a slight edge, perhaps because managers of funds in this sector are afforded more flexibility. Not only are they restricted to higher grade bonds – BBB- or above to be precise – they can take the short-term tactical decision to move into other fixed interest instruments for limited periods.

To be fair, this makes little difference to the average fund. True, over the past six months, arguably a difficult period with the US election and signs of rising inflation, the average Strategic Bond fund was up 1 per cent, while the average Corporate Bond fund fell by more than 1 per cent, but over one year Corporate Bond inches ahead and establishes a more convincing lead over three years: +16 per cent compared with +12.3 per cent, and at +32 per cent over five years, beats Strategic’s +29 per cent.

Individual funds are another matter. Muzinich’s Credit fund easily beats the top corporate bond fund over six months and one and three years. Formed nearly 30 years ago in New York, Muzinich specialises in credit and established a London base in 1999. The Schroder Institutional Long Dated Corporate Bond fund tops the charts over one, three and five years, recording rises of 14 per cent, 33 per cent and 63 per cent respectively, though it appears to have fallen off a cliff recently, coming in 77 out of 80 over six months.

Many advisers tend to forget bond markets dwarf those of equities and there are a variety of sub-asset classes contained within the fixed interest sector. Specialist bond fund managers have been overwhelmed in recent years and one of the longest established, Pimco, hardly features, though it has three funds in each sector. Perhaps the other funds deserving of a mention in the Strategic Bond sector, aside from the Muzinich fund, are Artemis High Income, Royal London Sterling Extra Yield and Axa Framlington Managed Income, all of which are either in, or just outside, all timeframes reviewed.

KEY TAKEAWAY

Bonds generally produce higher yields and lower volatility than equities, though historically equities yielded more than British Government securities (gilts) to reflect the greater inherent risk. The difference in yields was referred to as the yield gap, but until comparatively recently the reverse was true, leading to a reverse yield gap. Inflation could well bring this about again, probably through a rise in bond yields and consequent fall in their capital values, but this asset class will remain a core investment area for many, notably pension and insurance funds, and should continue to be considered for appropriate investors, Corporate Bonds for the cautious and Strategic for the more adventurous.

THE NUMBERS

7.6% Average return in the IA Sterling Strategic Bond sector over one year

20.1% Performance of the Muzinich Global Tactical Credit fund over one year

71 Number of funds in the IA Sterling Strategic Bond fund sector over six months

12.3% Average return in the IA Sterling Strategic Bond sector over three years