Richard Macey, director of charities at M&G Investments, looks at five factors to help assess the suitability of individual bond funds in a rising-rate environment.
As economic activity strengthens in the US and UK, central bankers are increasingly hinting that interest rates may have to rise for the first time in many years. It’s a prospect that has got investors reviewing the possible effects on their bond portfolios, as areas of the fixed income markets are particularly sensitive to higher interest rates through a well-known inverse relationship: rising rates lead to falling bond prices and vice versa.
So what case can be made for investing in bond funds against this change in outlook? Relevantly, interest rate increases don’t necessarily mean negative total returns (the combination of income and growth of capital) for all fixed income assets. Consequently, funds with flexible investment mandates can look to deliver performance in a variety of market conditions.
Experienced bond fund managers with the backing of extensive credit research teams can often enhance this ability. The analysis below highlights five key factors to help assess the suitability of individual bond funds in a rising-rate environment:
1. Active duration management
Different types of bonds have different sensitivity levels to changes in interest rates, a concept known as duration. Bonds with high sensitivity to rate changes have long duration, while those with low sensitivity to rate movements have short duration.
In anticipation of interest rate rises, fund managers with the freedom to actively manage duration can take a bias towards short duration bonds so as to significantly reduce the impact of rising rates on the capital value of their portfolio.
2. Flexible asset allocation
Rising interest rates usually reflect an improving economic environment, and in such a scenario corporate bonds can perform well. This partly results as a better economy helps to strengthen profits and corporate balance sheets, which reinforces the ability of companies to meet their bond repayments.
In turn, there is a lower risk of ‘defaults,’ meaning the higher income offered by corporate bonds becomes increasingly attractive in compensating investors for holding these assets over less risky government bonds. Fund managers who can adjust their allocations between different asset classes in an unconstrained way can constantly re-assess where the best relative value lies in bond markets.
3. Experienced fund manager
The backdrop of historically low interest rates has been in place since the global financial crisis of 2008. Therefore, only those managers whose careers span further back from then are likely to have experience of managing fixed income portfolios through a cycle of rising interest rates.
4. Independent credit research
Large and experienced in-house credit research teams provide valuable input to bond fund managers as they weigh up their investment decisions. By carefully and thoroughly researching all types of fixed income securities, such proprietary, independent analysis equips select bond managers with a key competitive advantage.
5. Long-term income generation
Bond funds have the potential to offer a more predictable income for investors than other asset classes, such as equities, which are often considered to be riskier. As such, bonds can help to bring an important element of diversification to an investment portfolio. The income generated by fixed interest securities can also help to support investors’ overall returns if sentiment towards equity markets is negative and share prices decline. In turn, investors often want to know if a bond fund has provided a competitive and consistent income over time.
These views should not be taken as advice.
Richard Macey is director of charities at M&G Investments
Tel; 020 7548 3731
Email; [email protected]
Visit; www.mandg.co.uk/charities
With thanks to M&G Investments for their support with this blog
