Stabilise your portfolio with fixed-income exposure

8 September 2009

Stockmarkets worldwide have enjoyed a great summer run, as have some fixed-income sectors, but there’s considerable disagreement about the outlook.

Some believe the upward trend has further to run as those who have stayed on the sidelines decide to join in. Others think economic problems remain dire, and it’s time to take the profits and beat a retreat.

The most sensible approach is to keep a well-diversified portfolio, with a mix of UK and overseas equities ready to benefit from further gains, plus some fixed-interest exposure to provide income and stability.

This begs the question as to which of the six fixed-income sectors to favour. Each has its own appeal, with the yield generally increasing with the level of capital risk.

So, funds in the UK Index Linked Gilts sector, which provide the greatest long-term protection of your buying power, yield far less than those in the UK High Yield Bonds sector, which invest in the highest credit risks.

If you’re uncertain, take a look at the Strategic Bond sector. Its constituent funds can invest in any part of the fixed-income market, as long as at least 80% of their holdings are denominated in, or hedged back into, sterling.

Their managers enjoy greater flexibility and can alter their mix of holdings according to circumstances. But this freedom makes the yields less predictable, so there’s a big difference in returns across the sector – for example, the Gartmore High Yield Corporate Bond fund was down 29.4% over the last year, whereas the L&G Dynamic Bond Trust is up 23.4%.

Invesco Perpetual Monthly Income Plus is one of the largest strategic bond funds. It has one of the best five-year records and one of the highest yields, but it has been exceptionally volatile over the last year.

Managers Paul Read and Paul Causer were too sanguine about the banks last year, and were badly hit by the slump in their bonds. However, they kept their nerve, and have been rewarded in this year’s strong recovery. Another factor was the fund’s unusual exposure of up to 20% in equities, which enhances the fund’s chances of long-term growth in income and capital, but also makes it more volatile.

The fund is currently aggressively positioned, with over half of the fund in high-yield bonds and 17% in equities. It has also increased its exposure to European bonds to up to around a third of the portfolio.

Nick Gartside, who manages Schroder Strategic Bond fund, regularly has most of its portfolio in overseas bonds. “The UK bond market is only 5% of the global market. There are more significant opportunities overseas,” he says.

The fund has done well over the last year by emphasising high-quality assets. Gartside thinks the economic outlook is improving, but a new threat is emerging – inflation: “Inflation is the enemy of the fixed-income investor, forcing up the yields on government and quality bonds.”

His reaction is to have 10% in US inflation-linked securities, and to bet on a narrowing of the yield gap between corporate and government bonds by buying the former and selling the latter short. 

Gartside has also cut the fund’s sensitivity to rising yields by reducing the average duration to a year, and has invested 30% in emerging market bonds. “Emerging markets have much less debt than their Western counterparts, yet their bonds offer higher yields,” he says.

Meanwhile, the performance of the Fidelity Extra Income fund is usually above the sector average, especially in difficult markets. Manager Ian Spreadbury says: “The macroeconomic picture is highly uncertain, so I advocate an approach focused on diversification and value.”

He’s worried sterling weakness may push up UK yields, so around half the portfolio is in overseas bonds, hedged back into sterling.

Strategic Bond Funds

Return on £100 investment
under management
Yield 6 months 1 year 3 years
Fidelity Extra Income £361m 5.6% £96.02 £96.28 £110.01
Gartmore High Yeild
Corporate Bond Fund
£60.6m 9.4% £80.56 £73.23 £85.23
Invesco Perpetual
Monthly Income
£2,164m 8.1% £92.89 £94.89 £117.34
L&G Dynamic
Bond Trust
£320m 4.3% £123.4 n/a n/a
Schroder Strategic
Bond Fund
£130m 3.4% £103.75 £106.34 £120.31

IMA £ Strategic Bond
Fund Sector

 n/a n/a £93.24 £91.91 £103.54
FTSE All Share Index  n/a  n/a £79.51 £81.85 £116.32
UK 10-year Gilts Index  n/a  n/a £103.19 £110.88 £118.09
Source: Lipper. The figures show returns on £100 over three periods to end June 2009, with net income re-invested. They do not allow for initial charges, which may vary according to how the investment is made.


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