| Bond fund managers are complacent about the risks they face and investors can expect losses if these rosy assumptions are shattered.
This is the view of one investment expert who interviews fund managers all the time. Adrian Lowcock of Hargreaves Lansdown said some bonds were currently “priced for perfection” – in other words, were certain to fall in value if the economy or other factors produced any surprises in the coming months.
“We are in a world full of risk and uncertainty, from the unwinding of QE in America to the dangers in Ukraine, yet some bond fund managers seem to think that nothing can go wrong,” Mr Lowcock said.
“They are prepared to accept interest payments on their investors’ money that will prove too low to compensate for the risks in any but the most benign circumstances.”
He said the dangers were particularly acute for funds that had used “high-yield” bonds to boost returns. These assets, also called “junk” bonds, are issued by companies not considered strong enough to be certain to repay the money they borrow.
Because of the extra risk involved in lending to such firms, interest rates on their bonds tend to be higher than those on ordinary, “investment-grade” corporate bonds.
However, the interest rate premium on high-yield bonds – the difference between what they pay and what you get from safer corporate or government bonds – has been falling as investors search for income and fears about the economic crisis recede.
“Some bond fund managers are accepting too little interest in return for the risks of holding these bonds,” Mr Lowcock said. “They assume that interest rates are not going to rise for at least a year, that bankruptcies among riskier companies issuing bonds will remain rare, that nothing unexpected can crop up to derail the markets.
“We are always worried when fund managers show this kind of complacency – they are holding assets that are priced for perfection.”
The failure of investors to demand proper compensation for the risks they were taking was one of the causes of the subprime credit crisis .
Jeffrey Gundlach, founder and chief executive of DoubleLine Capital, an American bond fund house, described corporate bonds as “the most expensive they’ve ever been in history”.
But some highly regarded fund managers said there was still a place for high-yield bonds in their portfolios. John Pattullo of the Henderson Strategic Bond fund said: “Default rates among high-yield bond issuers are very low and hence arguably justify the low interest-rate premiums.
“Yes, these are premiums above government bond yields that are themselves artificially low, but perhaps we live in a low-growth, low-interest-rate and low-default world.
“In Japan default rates have been very low and it feels that parts of Continental Europe are turning Japanese, with zombie companies that just keep getting refinanced. That is a favourable environment for this type of investing.”
Talib Sheikh, manager of the JP Morgan Multi-Asset Income fund, said he had cut his holding of high-yield bonds from about 50pc of the fund to the “high 20s”.
He added: “With interest rates of about 6pc and only 1pc of issuers going bust, there is value here. These bonds typically lose money going into a recession, not coming out.”
Alan Higgins, a senior investor at Coutts, the private bank, said: “In high-yield bonds, the current yield advantage over government bonds, adjusted for volatility and default risk, compensates investors for the higher risks assumed, although it remains important to be selective.” Rodica Glavan and Colm McDonagh, two bond managers at Insight, said high-yield bonds offered “some of the best value across the whole fixed income spectrum”.
Which bond funds are best placed to protect your money?
Here are some bond funds that experts say should cope with whatever the markets throw at them over the next few months.
Kames High Yield Bond
Adrian Lowcock, of Hargreaves Lansdown, said Claire McGuckin, the manager of this fund, was not among those who downplayed the risks to the sector. “She told us there was no obvious trigger for bonds to fall – and that this in itself concerned her,” Mr Lowcock said.
“She is less relaxed about European high-yield bonds and so has moved towards their equivalents in America, where yields are better and the market is bigger, more liquid and better developed.”
Invesco Perpetual Tactical Bond
This fund is managed by the highly regarded Paul Causer and Paul Read. “They are good at positioning the fund in the appropriate bonds for any particular circumstances,” said Mr Lowcock. “They are very active and have high conviction about the choices they make.
“We like the fund, but its returns are by no means guaranteed. The managers still hold high-yield bonds but focus on short-dated bonds and those issued by certain financial firms, which they believe will get paid back. The fund has a lot of cash that it could use to provide firepower in any setback – the managers believe we are at the start of a prolonged bear market.”
Kames Absolute Return Bond
With an “absolute return” remit, this fund aims to avoid significant losses in all market conditions . The biggest loss that the unluckiest investor could have made would have been just 0.2pc, according to FE Trustnet, the fund analyst.
It invests in all types of bond, ranging from the safest government bonds through to high-yield and emerging-market bonds. The fund also uses complex “derivative” instruments to be able to “short” certain bonds – in other words, gain if the price falls.