Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest. 

The past month has brought with it the seemingly improbable combination of rising  inflation and higher government bond prices. In theory, this shouldn’t happen. Rising inflation is the biggest challenge likely to face assets producing a fixed income. It erodes the present-day value of the future interest payments a bond will make, as well as the amount an investor gets back when a bond matures.

From a markets perspective, however, we shouldn’t be too surprised. Bonds struggled around the turn of the year in expectation of the global economy lifting off. Now that it has, there is, perhaps, room for a discussion to take place about whether bond prices overreacted to the downside earlier this year.

Last week we learned that officials at America’s central bank now expect core inflation in the US to reach 3.4% this year, about 1% higher than the level they were anticipating in March. Expectations of US rate hikes were also brought forward by about a year, to 20231. Higher interest rates tend to depress the prices of bonds with maturity dates across a broad range. Rising inflation tends to cause the prices of longer dated bonds to fall the most.

In the face of this latest danger, however, government bond prices have shown resilience. Benchmark 10-year US Treasuries yielded about 1.5% last week, less than the 1.74% they did at the end of the first quarter of the year2. Yields move in the opposite direction to prices.

There are a number of reasons why bonds may have been rallying. Central banks continue to buy them in support of their countries’ economies through so-called quantitative easing programmes. In the US, this bond buying is still being conducted at a rate of US$80 billion per month3.

The buying of 10-year Treasuries may also have been partly driven by bondholders swapping out of longer dated bonds in order to limit their exposures to inflation risk. Then there is the perennial demand from both US domestic and foreign investors seeking the safe haven characteristics of US Treasuries to help balance the risks they have elsewhere.

So far, we’ve discussed the bonds issued by governments – called Treasuries in the US and gilts here in the UK. Individual companies also issue bonds – called company or corporate bonds – that share some similarities with government bonds, but which have other characteristics too.

From an investor’s standpoint, a corporate bond can be considered as having two main elements. The first of these behaves similarly to a government bond, responding primarily to changes in the outlook for inflation and interest rates. The second part reflects changes in the credit quality of the issuing company. Credit quality is affected by many things, including the state of the economy, a company’s trading performance and the amount of debt a company has.

Some professional investors – including bond fund managers – construct “synthetic bonds” of their own, with the maturity dates they want when suitable instruments aren’t available readymade in the market. They do this by purchasing first, a government bond of the desired maturity in the issuing country and second, by selling a derivative product that financially protects its owner from a worsening in a company’s credit quality. By selling that protection, the bond investor effectively assumes a share of the company’s credit risk. It’s an odd example of selling something in order to gain an exposure.

This is though, to some extent, to digress. The important point is that bond investors have the option to invest in corporate bonds as well as government bonds, in order to diversify and to achieve a higher income. Corporate bonds tend to offer higher yields because they are of inferior credit quality compared with government bonds.

Since credit quality may be a partial function of the strength of the economy and how well a company is performing, a corporate bond has the potential to perform better than a government bond when the economy is growing, all other things being equal. Clearly, investing in both types of bond at the same time opens the door to building a fixed income portfolio that is somewhat more resilient to the ebb and flow of inflation and interest rate expectations than a portfolio consisting solely of government debt.

This may well be preferable to abandoning bonds entirely when the economy is growing strongly. As noted at the outset, bonds have the ability to surprise to the upside – over shorter time frames especially – even when the prevailing economic winds seem less than favourable.

Critically for large numbers of investors, bonds tend to be more resilient than equities in times of market stress, and often move in the opposite direction to stock markets at such times. As such, they can be useful allies when the next, unexpected “black swan” event arrives.

Last year’s coronavirus crisis saw bond prices rise sharply between mid January and early March, which helped to cushion the blow for investors who happened to own both types of asset4. So-called balanced funds – such as the Fidelity Select 50 Balanced Fund – always maintain positions in both equities and bonds – it’s just the amounts allocated to each that change.

Investors aiming for an exposure to bonds with a maximum amount of flexibility would do well to consider a “go-anywhere” strategic bond fund. These have the ability to invest in a wide range of fixed income instruments, from government and investment grade (high quality) corporate bonds, to high yield corporate bonds (lower quality) and even emerging markets debt.

This flexibility provides the scope necessary for a skilled manager to capitalise on shifts in sentiment and emphasise those areas in the fixed income sphere and beyond offering the best prospects at any one time.

There are few more skilled managers in this regard than M&G’s Richard Woolnough. The £2.1 billion M&G Optimal Income Fund run by him aims to deliver both income and capital growth. It invests globally in both investment grade and high yield corporate bonds, as well as government bonds and even equities (the latter up to a maximum of 20% of the portfolio). Charges are taken from capital for the Fund’s income share classes, but from income for the accumulation share classes. The Fund features on Fidelity’s Select 50 list of favourite funds and currently yields approximately 2.0%5.

Finally, it’s worth remembering there is a way to benefit directly from rising inflation, and that’s via inflation or index-linked bonds. The interest payments from these types of bond, along with the amount an investor gets back when a bond matures, increase as inflation rises.

This could prove extremely useful in the current environment and particularly so if central banks are wrong in their current assumptions that higher inflation will prove temporary. Fidelity’s Select 50 list includes the £1.0 billion Global Inflation-Linked Bond Fund, which benefits from a dedicated inflation team at Aberdeen Standard Investments. The Fund aims to generate income and some growth over the longer term6.

Source:

1 Federal Reserve Bank, 16.06.21
2 US Department of the Treasury, 17.06.21
3 Federal Reserve Bank, 16.06.21
4 Bloomberg, 17.06.21
5 M&G Investments, 17.06.21
6 Aberdeen Standard Investments, 31.05.21

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Select 50 is not a personal recommendation to buy or sell a fund. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. The M&G Optimal Income Fund and ASI Global Inflation-Linked Bond Fund use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Currency hedging is used to substantially reduce the effect of currency exchange rate fluctuations on undesired currency exposures.  There can be no assurance that the currency hedging employed will be successful.  Hedging also has the effect of limiting the potential for currency gains to be made. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Share this article

Latest articles

Market news today - 20 September 2021

What’s driving your investments this week?


Tom Stevenson

Tom Stevenson

Fidelity International

Where next for Kingfisher shares as Screwfix-owner gives update?

Can the lockdown DIY frenzy sales boom persist in a re-opened world?


Emma-Lou Montgomery

Emma-Lou Montgomery

Fidelity International

Stop worrying about a crash: the bull market has further to run

Should investors really worry about inflation, Covid and US tapering?


Tom Stevenson

Tom Stevenson

Fidelity International