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Challenging times for bond investors

As there has been a lot of media attention on the fixed income bonds recently, our bond specialist, Robert Harley, gives our view.

The price of fixed income bonds have an inverse relationship with their yields: bond prices increase as yields fall, and vice versa when they rise. More recently the yields of western government bonds have risen sharply, amid concerns that the US Federal Reserve will start to wind down its bond buying programme as the economy shows signs of sustained improvement. To date this programme has arguably provided artificial support to the price of government bonds by keeping yields lower than they would otherwise be; the risk being that when this support is removed, yields will revert to more normal levels.

Within the fixed income universe certain categories of bond are more sensitive to rising government bond yields. Foremost amongst these are quality corporate bonds. Other bonds such as shorter maturity and high yield bonds are generally less sensitive to this scenario. As a result the former have recently experienced capital losses similar to government bonds. Whilst shorter dated and high yield bonds have also seen some erosion of capital value, these losses have generally been more limited.

Review your allocation

We believe investors who have significant exposure to gilts or quality corporate bond funds should review their allocation to these assets classes or alternatively the type of fund they are invested in with a view to mitigating further potential losses associated with the risk of rising yields. Funds we consider to be most at risk are core gilt, index linked gilt and quality corporate bond funds that tend to carry high sensitivity to rising yields. Examples of our rated funds which invest in these areas include: Legal & General Fixed Interest,M&G Corporate BondFidelity MoneyBuilder Income and Royal London Corporate Bond.

Alternative funds

As an alternative, investors may wish to consider short duration bond funds, strategic bonds funds or high yield bonds funds.

Short duration bond funds invest in shorter maturity bonds or alternatively they might use derivative instruments to structurally reduce their exposure to loss from rising yields. The income yields on these types of funds tend to be lower than their core equivalents.

Strategic bond funds are more flexible fixed income mandates that carry fewer portfolio construction constraints. These funds generally give the portfolio manager access to the tool kit to manage the risk associated with rising yields. However they can also come at the cost of lower absolute yields and there is no guarantee that the portfolio manager will necessarily position a fund for such a scenario.

Core high yield bond funds have historically offered low correlation to government bonds and might be seen as an alternative investment solution in such an environment. Whilst the low absolute yields currently on offer suggest more caution than usual may be warranted, on a two to three year view the total return outcome could still compare favourably.

Fund examples include: Legal & General Dynamic Bond (five star)Kames Strategic Bond (five star), AXA US Short Duration High Yield (three star) and AXA Global High Income (five star).

Looking forward investors should adjust their fixed income return expectations in line with the prevailing low yield environment and the risk of volatility in government bond yields. There is no doubt that solutions for income seeking investors within the fixed income universe are also becoming more challenging given the market backdrop – invariably investors are being pushed further up the risk scale in their efforts to meet minimum income requirements, as a consequence it is important investors do not lose sight of their original portfolio objectives.

The value of your investment can go down as well as up, and you can get back less than you originally invested.

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