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How to invest in bonds when interest rates are rising

Written by: Adrian Lowcock
The bull market in bonds is clearly over and we are now in a phase of rising interest rates. This doesn’t mean the bubble will burst but it impacts how investors should think about their bond exposure.

It is easy to overlook the moves in the bond markets last month as investors focus on the volatility that has entered stock markets. But the moves are significant. They signify a change in outlook bond investors haven’t seen in over 30 years.

While the Bank of England decided to keep interest rates at 0.5% this month, Governor Mark Carney did hint that interest rates are also likely to rise faster than it had initially forecast.

Rising interest rates are generally bad for bond prices. As the base interest rate set by the Bank of England rises (often called the risk-free rate), then the yield on government bonds rises to reflect this. That sends bond prices down, causing investors to lose money.

The bond market is complex. Different parts of the market behave and respond differently to a range of factors. For example, interest rate rises have a greater impact on bonds with a low risk of default such as government bonds, compared to high yield bonds.

Longer dated bonds are also more sensitive to the changes in interest rates whereas with short dated bonds, the focus is more on the imminent return of capital.

Corporate bonds tend to be more sensitive to the economic outlook and the underlying company’s financial situation. Understanding all the factors affecting bond prices and how they interact with each other means there are still plenty of opportunities to make money from investing in bonds.

While interest rates are expected to rise, the economic backdrop remains very benign, the global economy looks stable and fairly healthy for the first time since the financial crisis. Even with interest rates rising they are coming from a low base with many companies having already renegotiated their debt at these low levels. This is all good for corporate bonds as there are low defaults, companies are easily able to make the interest payments and even if interest rates do go up higher than expected they will still remain fairly low.

Over the years, bond managers have also developed new tools to ensure they can make money for investors in all market conditions. The use of derivatives means they can now profit from rising yields as well as falling ones. Managers can also reduce interest rate risk by buying short dated bonds. There are also many niche sectors and areas of the bond markets, such as asset backed securities, which offer more attractive returns for taking a similar risk.

The key to success in investing in bonds now is making sure you have the right fund for the job. Some funds are more rigid than others and offer the manager little flexibility which is going to be needed with the bull market over. A manager’s skill and the strength of the team is also going to be worth a lot more in the coming months and years.

Three bond ideas for investors

Kames Strategic Bond

The managers believe they can generate an attractive return through a flexible approach to fixed income markets. The team are well resourced and incorporate a macro view, along with looking at bottom-up fundamentals when selecting bonds. They are fairly tactical and are willing to exploit sell-offs in sectors although they do take long-term views when investing. The fund should provide more defensive protection than some of their peers.

TwentyFour Dynamic Bond

This fund is run on a team basis with each member having specialisms in fixed income. The investment committee establish the bigger picture view of the world leaving the managers to decide how and when to reflect this within the fund. The fund can go anywhere in the fixed income space and as such could be considered a best ideas fund.

Royal London Sterling Extra Yield

Manager Eric Holt runs this fund from a bottom up perspective and prefers to conduct his own fundamental analysis instead of relying on rating agencies in order to identify undervalued assets. There is a focus on un-rated investments which are often ignored by other managers and differentiates the fund from other UK Corporate bond funds, but also means this fund is riskier and more akin to a high yield bond fund.

Adrian Lowcock is investment director at Architas

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