ISA tips: Why owning these bonds still makes sense

Bond trusts have had a great run over the past 35 years as inflation and the yield on 10-year US Treasuries – the benchmark for the bond universe – have fallen from the mid-teens to low single figures.

Time and again the bottom has been incorrectly called, as happened in the second half of 2016, when the benchmark yield rose from 2 to 3%.

It was back around 2% by September 2017; but it has recently climbed back up to more than 2.5%, prompting fixed-income luminary Bill Gross at Janus Henderson to suggest that the bond bear market has begun.

This ties in with expectation that the US Federal Reserve will raise interest rates several times this year. If those moves lower the value of US Treasuries, many fixed-income products could be hit.

Room for bonds

However, other bond watchers believe that, barring a major upset, interest rates and inflation will continue to hover around current levels for the foreseeable future, thanks largely to secular trends such as the ageing of populations and technological advances.

Recent retail sales figures indicate that these bearish arguments have persuaded many investors to switch from bond funds to equity-based vehicles. However, in doing so, they must usually settle for lower yields.

Moreover, arguably, investors will not have reduced their downside risks, as many equities look fully valued after their long bull market run. It therefore makes sense for investors with diversified portfolios to continue to include some bond exposure in their portfolios.

Charles Murphy at Panmure Gordon suspects that interest rates will rise, so he suggests investors avoid trusts focusing on higher-yielding and lower-quality bonds, as they are currently trading at prices that make little allowance for defaults, which are liable to occur more frequently as interest rates rise.

In addition, most high-yielding bond trusts are trading at premiums that could fall if their portfolios are rattled by rising rates.

Murphy prefers trusts such as JPMorgan Global Convertibles Income Fund (JGCI), which trades at a discount, has exhibited low volatility and offers a 4.6% yield. “It is currently all in out-of-the-money convertibles (convertible loan stock that is unlikely to be worth converting), so it is like a bond fund,” he says. He also likes Henderson Diversified Income (HDIV), and two trusts invested mainly in floating-rate debt, namely the sterling shares of NB Global Floating Rate Income (NBLS) and TwentyFour Income Fund (TFIF).

The former invests mainly in senior secured loans. These must be repaid before other debt obligations and bond and equity holders if there is a problem, which has helped the trust keep its NAV per share steady since its April 2011 launch.

Its income is linked to bank Libor rates and is fully distributed each year, so its dividends have trended down as interest rates have fallen.

Theoretically, they will rise as interest rates rise, but the catch is that the issuers of floating-rate loans are generally permitted to refinance them at any time, and when rates are rising they may be able to do so at a lower margin over Libor, thereby more than offsetting the interest rate rise.

Source: Numis Securities     Past performance is not a guide to future performance

Past performance is not a guide to future performance

Delve into the dividend

TwentyFour Income Fund (TFIF) invests in portfolios of UK and European asset-backed securities such as collateralised loan obligations and residential mortgage-backed securities.

Many of the asset-backed securities it invests in are hard to understand and too illiquid to interest open-ended funds, which tends to enhance their yield, and although their holdings are generally floating rate, they appear to be at relatively low risk of refinancing.

TwentyFour has regularly exceeded both its minimum dividend target of 6p a year and its total return target of 6-9%, and the manager expects returns to increase as rates rise.

Numis Securities and Winterflood have both recommended the fund recently.

Henderson Diversified Income might deter many, as more than 60% of its portfolio is in fixed-rate high-yield bonds; nearly 60% is US quoted; its interest rate duration (its sensitivity to rising interest rates) is comparatively high, as is its gearing (in the high teens); and it is cutting its annual dividend from 5p to 4.4p.

However, its dollar exposure is all hedged into sterling; its managers John Pattullo and Jenna Barnard are very picky about issuers; and gearing boosts the yield on the portfolio, allowing the managers to invest around 25% in investment-grade bonds.

Henderson’s long-term returns have pulled steadily ahead of its benchmark of three-month Libor plus 2%, and Pattullo and Barnard are determined to maintain a reasonable yield while protecting shareholders from long-term capital destruction.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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