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.

In the asset popularity contest, equities tend to steal the limelight. They’re the companies we recognise, the products we use, and the stories that grab all the headlines. But beyond global share indices there is a $100 trillion market1 focused on one area investors can’t forget - bonds.

They aren’t as flashy and can take a bit more effort to fully understand sometimes so they often play second fiddle in many investors’ portfolios. However, getting a firm handle on what bonds are and how they interact with other assets can help us all add another dimension to portfolio diversification.

What are bonds?

Think of bonds as loans we make to governments and countries. In return, we can expect our lump sum back at the end of the agreed term, as well as regular interest payments along the way. The length of the loan and the creditworthiness of the government or country borrowing your money help decide the level of interest you receive.

If the borrower fails to pay back their debt they can default on the bond, so lenders often demand a higher rate of interest from institutions they deem risky. Since the price of a bond moves the opposite way to interest rates, if rates rise, bond values fall.

Making the right calls on assessing these two risks, namely credit risk and interest rate risk, as well as inflation, is perhaps the central task of bond fund managers. These are the factors that, in large part, determine the price that the market is willing to pay for bonds.

So why would we get mixed up in all the maths? Well, bonds have traditionally been a good asset to hold alongside equities for diversification. They’re commonly lower down the risk scale than individual shares and generally act differently, giving your portfolio the chance to have at least some cylinders firing at any one time.

How to invest in bonds

For most people, the easiest way to invest in fixed income is by outsourcing all the day-to-day research and investment to a bond fund manager. The Fidelity Select 50 list of our analysts’ favourite funds features a range of management styles, each with their own objective and blend of different types of bonds.

The iShares UK Gilts All Stocks Index Fund is a passively managed option, providing diversified exposure to UK government bonds. As governments tend to have higher credit ratings than companies, government bonds are generally considered to be the safest of the bunch. With the reduced risk of default come lower interest rates.

When it comes to actively managed bond funds, the goal of the manager is to form an accurate picture of how creditworthy governments and companies are, and whether the reward on offer merits the risk taken in exposing investors to possible default.

The Fidelity MoneyBuilder Income Fund primarily invests in sterling-denominated bonds issued by companies. Manager Sajid Vaid believes investment grade (high quality) company bonds may be the ‘sweet spot’ in the fixed income market, delivering modest income while keeping risks in check. Vaid ensures careful research is undertaken to minimise default risk.

High yield bonds offer the potential for higher long-term returns than investment-grade bonds but this can mean higher default rates and greater volatility.

Opportunities arise for the team behind the Invesco High Yield Bond Fund when their views on creditworthiness split from those of the market. What other investors avoid may be a chance for the managers to scoop up a higher quality bond at an attractive price.

Similarly, the Indianapolis-based JPM Global High Yield Bond team prizes bottom-up research, digging into companies’ financial statements and meeting company management. If firms do default on their bonds, the managers often work with the borrower to resolve the situation.

Like other bond funds, Jupiter Strategic Bond invests in the debt issued by governments and companies around the world, but the ‘strategic’ part gives it a wider universe of debt to turn to. While traditional bond funds stick to one part of the fixed income universe, manager Ariel Bezalel is able to move wherever he and his team find opportunities, be they in the emerging economies of the world or higher risk areas of corporate debt. He can also bet against price rises if he sees fit, through the use of derivatives.

Likewise, the flexibility afforded to Fidelity Strategic Bond, thanks to the lack of benchmark constraints, highlights the strategy’s distinction from that of traditional bond funds. Co-manager Tim Foster believes the specific goal of performing differently from equities means the fund can act as a diversifier for equity-heavy portfolios.

Low volatility, a reasonable income over the cycle and low correlation with equities are the main tenets of the fund, as the manager seeks to provide a one-stop shop for those looking for a fixed income solution.

Flexibility is also a characteristic of the M&G Optimal Income Fund. Manager Richard Woolnough is not compelled to invest in specific parts of the market where returns might be correlated with what’s happening in the economic cycle. Optimal Income is unusual in having the freedom to invest a portion of its holdings in the stock of individual companies if they look attractive relative to bonds.

Woolnough also runs the M&G Corporate Bond Fund, investing in corporate bonds with the aim of providing a higher total return than UK government bonds with the same maturity. M&G has a team dedicated to analysing bonds close to or in default, often working with borrowers in default to renegotiate terms on behalf of investors, should the situation arise.

Adam Skerry argues that index-linked bonds offer protection to a traditional bond portfolio of government and corporate debt when there is the expectation of rising inflation. Through the ASI Global Inflation-Linked Bond Fund, he aims to outperform the global inflation-linked government bond index. The manager believes the experience and expertise within the Aberdeen Standard team structure gives them an incisive edge over less-experienced teams in the industry.

Colchester Global Bond managers, Ian Sims and Keith Lloyd, pin their medium to long term strategy on two key tenets: a value-driven process, and an exclusive focus on sovereign bonds and currencies.

Investing exclusively in sovereign debt is fairly unique for bond funds. And while high-quality holdings form the bulk of the fund’s portfolio, generating meaningful return is also central to the managers’ objectives. Sims and Lloyd have both the willingness and the ability to take sizable positions in smaller markets where they believe lies the greatest value.

It is by swimming against the current that this fund’s managers hope to uncover the best opportunities in a value-rich marketplace.

Source:

1 Securities industry and financial markets association 2017

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Select 50 is not a personal recommendation to buy or sell a fund. 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. 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. 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.

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