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BLOG: Is this the obvious investment choice in an uncertain market?

Paloma Kubiak
Written By:
Paloma Kubiak

Things have changed dramatically for investors in the past 18 months as rising interest rates amid an inflationary backdrop continue to spook markets. Are bonds the obvious choice for investors?

Having been as high as 11% in October 2022, UK inflation remains stubbornly high (7.9% in June), with the Bank of England (BoE) citing a series of shocks to the economy – namely Covid, Russia’s invasion of Ukraine and the big fall in the number of people available to work – as the main causes.

The BoE is hopeful inflation will fall to around 5% by the end of this year, and reach 2% (its target) by early 2025. The impact is we are now expecting rates to peak at 6% – with some analysts expecting them to go higher than that – something that anyone under the age of 30 will not have experienced during their working careers.

As a consequence, high growth companies (think of the tech giants like Amazon, Alphabet and Apple) are no longer the “go-to solution” for investors as they were in the days of quantitative easing (QE) and, all of a sudden, UK corporate bonds are starting to look a sensible choice to navigate the continued uncertainty in markets.

The ugly duckling turns into a swan!

Without going to intense detail – barring a few brief spells of outperformance, bonds have been an unattractive place for a number of years. It was only back in 2019 when around 30% of bonds issued by Governments and companies worldwide were trading at negative yields.

But things have changed as figures from the Investment Association showed Fixed Income funds have recorded almost £5bn of net inflows in the first six months of 2023. Of particular interest is the Sterling Corporate Bond sector, which has now seen inflows of almost £2bn in the past 12 months.

The basics of corporate bonds

For clarity, the yield on a corporate bond fund is made up of two parts – the risk-free rate (i.e. gilts) and the spread (the difference in yield between the corporate bond yield and the risk-free rate on Government bonds). Spreads are historically attractive on fixed income at their current levels, but not at the levels we saw on the back of the Global Financial Crisis or Covid, when interest rates were at record lows. As of writing the two-year gilt stands at just under 5%, so you should be looking for around 7% from a UK corporate bond (2% above the risk-free rate).

Not only is the income as healthy as you could ask for – but the risk is lower than it used to be. The bond market is full of bonds issued during the QE era, with lower coupons coupled with strong yields offered today. Artemis Corporate Bond fund manager Stephen Snowden says the average price of a bond in the sterling corporate bond market today is 87p in the pound. Essentially for every £100 claim on a company you are paying £87 on average across the sector.

So they are cheap and offering an extremely attractive income. But there are dangers, not least the threat of recession for the UK – particularly as people roll off their existing mortgages onto far more expensive alternatives, thanks to rising rates. One million UK mortgage holders could see their disposable income fall by 20% because of rising rates, according to the Institute for Fiscal Studies (IFS).

The argument is you are being rewarded handsomely to take this risk. If we do fall into a deep recession, the Government will cut yields but that should boost the capital returns from corporate bonds.

Snowden says estimates indicate inflation will be in the region of 3-4% in the next 10 years. In that scenario corporate bonds look incredibly attractive as you will get a decent yield now. Although if interest rates go down, bonds will rise, and you will get a capital uplift/improved investment returns.

Going active and investment options

The final point is there is now greater dispersion of prices in the bond market making it ripe for active managers to find opportunities. During 2008 you had bank bonds trading at 10-30p in the pound, whereas utility/telecom bonds were being treated like royalty. Bonds were either incredibly cheap or expensive – very few bonds traded at the average level. QE levelled out the price of bonds to a large degree, but that dispersion is back now in the post-QE world, and that means opportunities for active managers.

Experienced active managers worth considering in this space include Richard Woolnough and Ben Edwards, who manage the M&G Corporate Bond and the BlackRock Corporate Bond fund’s respectively. While those who might prefer a monthly income offering might consider the Liontrust Sustainable Future Monthly Income Bond fund, which has the flexibility to move between shorter- or longer-dated bonds in order to take advantage of changes in interest rates.

Darius McDermott is managing director of Chelsea Financial Services and FundCalibre