Bonds currently offer great value for long-term investors when compared to equities, and the prospect of falling interest rates later this year reinforces the favourable timing of increasing exposure to the fixed-income market.
The thesis is simple. Current market yields are trading very near long-term averages and central banks look set to cut interest rates. When you throw in the frothy valuations of equity markets, it’s very difficult to argue against including a decent bond fund in your portfolio.
There are various options available to investors, and for those new to fixed-income assets, the bond market may be off-putting. It needn’t be.
Investors will first need to choose geographical exposure. Do you want exposure to the US, Europe, the UK, or even emerging markets?
Our selections focus on the UK and the US because their yields offer better value and are inherently less risky than those of other jurisdictions. Emerging market bonds will have their time, but the value just isn’t there at the moment.
Once the geographical decision has been made, the next choice is the vehicle and fund management mandate. If you would like to gain greater diversification and employ the expertise of a fund manager, a unit trust or OEIC is the way forward.
For the more tactical investor happy with their convictions, an ETF or a selection of ETFs may be the best option.
Bond ETFs
The iShares 20+ year US Treasury Euro hedges ETF (DLTE) and SPDR Bloomberg 15+ Year Gilt UCITS ETF (GLTL) will do an excellent job of providing exposure to long-dated bonds as interest rates are cut.
Long-dated bonds are more sensitive to changes in interest rates and can be more volatile than short-dated bonds. Volatility often has negative connotations, but for the purpose of these selections, we look at volatility favourably. When interest rates eventually fall – and fall they will – the capital appreciation potential for long-dated bond ETFs becomes very interesting.
You’re locking in a yield of above 4% with the chance of 10%-20% capital growth, depending on how far interest rates fall.
The big risk to the value of these ETFs – as it is with all government-issued bonds – is the return of inflation. Should inflation start to heat up, bond yields will rise, and their value will depreciate as the market prices in higher interest rates. In this scenario, the value of the ETFs will fall, but you will have locked in your yield.
The likelihood is both the US and UK move to cut rates at a similar time, although there may be minor differences in the timing. For example, the Bank of England is facing a much tougher economy in the UK than the Federal Reserve is, so there’s a good chance the BoE cuts first. One must also consider the extent to which the Federal Reserve and Bank of England cut rates.
Owning a spread will even out the gyrations and protect against one moving more slowly or not as far as the other.
M&G Optimal Income Fund
For investors seeking a little more depth in their exposure to bonds, the £1.5bn M&G Optimal Income Fund OEIC is a solid option.
The M&G team behind the M&G Optimal Income Fund, headed by Richard Woolnough, prides itself on doing things differently. Woolnough points out that many bond funds tread a very well-worn path, and it’s difficult to see any variation in what they do. This leads to mediocre returns over the long term compared to the benchmark.
The M&G Optimal Income Fund’s approach has returned 7.7% over the past year compared to a benchmark return of 4.9%. The fund’s current yield to maturity net of fees is 5.1%.
The fund invests in both government and corporate bonds, providing investors with higher yields than they may otherwise achieve in government bonds only.
This does present a higher risk profile, but the fund’s active management style brings with it decades of experience from managers who have successfully navigated and learnt from major risk events in bond markets, including the European bond crisis of 2010 – 2012 and 2014’s oil crisis.
The team at M&G carefully alters allocations to government bonds, investment-grade corporate bonds, and high-yield corporate bonds (higher risk) in line with their views of the world.
As of 30 April, the fund was overweight government bonds compared to the benchmark as the managers looked to exploit the deep value in government bonds after the interest rate hiking cycle. The fund was also overweight generally more reliable investment-grade corporate bonds and underweight the riskier end of the corporate bond universe.
The current composition offers plentiful exposure to any revaluation in government bonds while providing diversification across the world’s leading corporates.
