Investors’ love of bonds cooled recently after the US confirmed it would soon start to wind down its quantitative easing progamme.

Both the equity and bond markets had become accustomed to the liquidity that money printing provided and the Fed’s announcement sparked a savage investor sell-off.

The bond markets have had a lengthy bull run, with investors enjoying low interest rates that has come hand-in-hand with QE.

However, when QE finally expires, bond valuations as they currently stand will not be sustainable, the main concern for fixed income investors.

Thant Han, a member the BNY Mellon Global Strategic Bond fund team, says that although investors are understandably spooked, these changes are unlikely to trigger a trend in downward prices: “While we have seen a sell-off in US Treasuries and equity markets in the past few weeks, we believe that the market needs to view this move in a positive light; it is ‘less easing’ rather than ‘tightening’. We do not believe it will usher in a cyclical bond bear market.”

As it stands, bond yields relative to cash are good, with a 4%-7% yield prediction depending on risk for credit. Government bonds will bring in much less.

Having said that, absolute yields are low, and if interest rates were to go up, then values will see a sharp fall.

Investors should note that if rates were to go up, there will be a likely rush to exit from the fixed income market, which in an already illiquid market may spell chaos for prices.

The question for investors is what to do with their bond holdings: abandon ship or keep some exposure?

Tom Stevenson, investment director at Fidelity Worldwide Investment, says investors probably invested in bonds for one of three different reasons: a reliable income, a capital gain and creating a well balanced portfolio of assets alongside some equities, cash and maybe property and commodities as well.

He believes two of these reasons still hold water: “Corporate bonds, if less obviously government ones, still offer a decent yield which, in a low interest rate environment, continues to look attractive. Bonds also tend to offer balance to a portfolio, responding in different ways than equities to changes in the economic backdrop.”

It is only the anticipation that prices have much further to rise that looks too optimistic today, Stevenson says.

Meanwhile, David Coombs, head of multi-asset investments at Rathbone Unit Trust Management, believes that investors should not overlook the fact that bonds still have a vital part to play in managing portfolio risk.

“In an environment in which investors can lose money in bond markets, should we be abandoning bonds and switching everything into equities? Absolutely not,” says Coombs.

“There are still opportunities in a rising yield environment. It’s more about how investors use bonds in their portfolios. You might still achieve a positive return, but importantly, bonds remain a crucial tool in managing risk. And amid the recent furore surrounding outflows, it’s important not to forget this.”

Bonds generally harbour three main risks: liquidity risk, credit risk and interest rate risk.

“The funds we favour are macro bond funds,” says Coombs. “They have flexible mandates that can switch between these risks, using quite complex tools. This means they are less directional and have the potential to make money in down markets.”

“All of these funds [see below] can short or zero weight these risks in a more efficient manner than a plain vanilla, long-only bond fund.”

However, investors are reminded that they should be clear about the underlying strategies employed by these and other macro funds, before including them in their portfolios.

How much of a portfolio should be devoted to bonds?

Stevenson says conventional wisdom is probably changing. For example, rules of thumb about the proportion of bonds that’s appropriate at different ages now tend to argue for more equities as investors approach retirement than they used to. But it remains a very bold call to say that an investor should have no bonds at all in their portfolio, he says.

“Diversification remains a cornerstone of a sensible investment strategy. That means spreading your investments between different countries and crucially between different asset classes. No-one knows what lies around the corner and the best way to handle that uncertainty is to put your eggs in plenty of different baskets.”

Stevenson says that the move towards strategic bond funds, funds that invest across the entire bond universe rather than just in one type such as corporate bonds, makes sense as far as an investor’s fixed income allocation is concerned.

This is because, with so much uncertainty around at the moment, it makes sense to leave the balance between government securities, investment grade and high yield bonds to an expert.

Ben Yearsley of Charles Stanley Direct says that for the time being investors should ‘stick with bonds’: “Interest rates aren’t going anywhere in the short term, although QE is being prepared to be tapered in the US it still isn’t being reversed, therefore although yields have risen there is still support.”

The funds that the industry experts like at the moment –

Yearsley – Kames Investment Grade Bond, Jupiter Strategic Bond, Royal London Sterling Extra Yield Bond.
Coombs – F&C Macro Global Bond, Ignis Absolute Return Government Bond, JP Morgan Income Opportunity.
Fidelity’s Investment Solutions Group – M&G Optimal Income, Legal & General Dynamic Bond Trust, Henderson Preference & Bond.