Can bonds still shelter you from inflation storm?

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The word ‘bond’ usually produces a feeling of calm, but presently it is having the reverse effect. Such is the anxiety about the outlook for the $100 trillion (£82trillion) global bond market that in the first week of this month, investors worldwide withdrew $9.7billion (£7.9billion) from bond funds. 

Is this flight the right response, as concern mounts that we could face a period of stagflation when growth is sluggish and the cost of living spirals? 

Or is the pessimism overdone, making this the moment to reassess the merits of bond funds, particularly if you need an income? 

Stormy: The word 'bond' usually produces a feeling of calm, but presently it is having the reverse effect

Stormy: The word ‘bond’ usually produces a feeling of calm, but presently it is having the reverse effect

The rush for the exit was spurred by alarm over soaring inflation and interest rates, which were raised again in the UK and the US this week. 

For bonds, rising interest rates and inflation are a toxic combination. 

They reduce the value of the fixed income paid out by bonds and of the capital invested. 

Bonds come in two categories – sovereign debt issued by governments to raise funds, and corporate debt issued by companies for the same purpose. 

The sense of foreboding is evident in the figures covering corporate bonds, UK government gilt-edged stocks or gilts (so-called because the certificates used are gilt-edged) and US Treasury Bonds or ‘Treasuries’. 

The Bloomberg Global Bond Aggregate index is down 15 per cent since the start of the year and the average UK government gilt-edged bond fund has fallen by about 14 per cent. 

The yield on a ten-year gilt is 2.54 per cent, against about 1 per cent in January, while the yield on their US equivalent, a 10-year US Treasury, is 3.29 per cent, up from 1.76 per cent over the same period. 

Yields, which move inversely to bond prices, have been driven up by the quantitative-easing (QE) schemes in which the Bank of England and other central banks bought up bonds to pump money into economies. Hardest-hit in the turmoil have been longer-duration bonds, set to mature from ten to 30 years hence. 

These are regarded as riskier since investors must wait longer for the return of their cash. 

Index-linked bonds, which offer inflation-proofing, have not been spared in the rout. As some investors will remember with nostalgia, bonds used to be the comfort-blanket element of a portfolio, trusted upon to thrive when shares tumbled. 

But, while optimism is in short supply, could such conditions offer an opportunity? 

US giant Citi has been suggesting for some weeks that this is the moment to get into bonds. It’s a view gaining popularity. But if you would like some exposure to the sector, tread cautiously. 

Contrary to what you would suppose, index-linked gilts do not necessarily provide protection against inflation unless held to maturity. When inflation is surging, they can lose money. 

High-yield bonds sound alluring, but they are issued by companies with lower credit ratings, which means a larger risk of default. 

Jason Hollands of Bestinvest comments: ‘Corporate bonds offer a higher degree of security for investors in the event that a business goes bust, since bondholders are higher up the pecking order for receiving any share of remaining assets than shareholders. 

‘Over the past decade, the level of defaults has been low. But, with the chances of a recession growing, defaults are destined to rise.’ 

James Yardley, senior research analyst at Chelsea Financial Services, also counsels caution: ‘Bonds are starting to look a little bit more interesting again. But I’d be particularly wary of corporate or high-yield bond funds just now. 

‘There’ll probably be a good chance to buy corporate bonds in the coming months, but I would wait for a recession to be fully priced in before doing so.’ 

Chelsea Financial Services has been increasing clients’ exposure to Treasuries as ‘an excellent portfolio diversifier’, while warning that if inflation remains elevated, there could be more pain to come. 

Yardley adds: ‘The yields on gilts and European sovereign bonds are still pathetically low. The risk/ reward for these is still not in the right proportions. The funds we like are M&G Global Macro Bond, BlackRock Corporate Bond and GAM Star Credit Opportunities.’ 

These funds hold a mix of gilts and the bonds of household name businesses. 

Hollands acknowledges that the income on offer from bonds is improving, but he points out that the yields are still below the rate of inflation. 

His bond choice is the MI TwentyFour Dynamic Bond, where managers deploy what they call a ‘highly flexible’ strategy. 

This is the approach that anyone venturing into bonds now should adapt. They were the laidback option, but that is just not so any more.

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