Last year was brutal for bonds. All-in-all 2022 was the worst year for global bond investors on record, as a result of the US Federal Reserve and its sister banks in the UK and Europe aggressively raising interest rates to try to get a cap on inflation. The fall-out was that bond prices got a real spanking – especially at the longer-dated end of the market.
Bonds are traditionally seen as the most boring, sleepy and reliable part of the investment market. Jokes about the tediousness of bond fund managers in financial services are almost as common as jokes about actuaries. In a climate of historically low interest rates and manageable inflation, bonds and cheap money were just something that everyone considered part of the furniture.
In a portfolio, bonds generally play the role of safety net or shock absorber, protecting diversified portfolios from the worst ravages of the stock market volatility. Traditionally, bonds – also known as fixed-income – are seen as a hedge against risk and volatility, because being debt instruments are usually quite predictable.
Predictability
Predictable in the sense that an investor can make a reasonably sound call on the financial health of the nation or corporation that is issuing the bond. You kind of know that the British Government is good for its debt, that’s why UK Government Bonds are known as gilts – because they are of the highest quality – virtually gold-rimmed – and an investor knows that the nation will pay on time, and at the interest rate it promises. In the corporate environment, bond-holders are first in line to receive any funds from a liquidator, should a company go bankrupt. So odds-on although you are not 100% guaranteed to get your money back, the risk of not getting anything is very low.
And so bonds were always seen as sleepy, predictable and safe. That was until 2022, when bond managers and investors thought that they were getting on ‘The Happy Caterpillar’ ride at Blackpool Pleasure Beach, expecting a gentle and benign circuit where they could wave to onlookers and enjoy the sights with a Cornetto, only to realise as the carriage pulled away from the platform that they’d erroneously got into the queue for ‘The Big One’ and would experience three quarters of petrifying, white-knuckle, trouser-filling terror.
Before we go further, I think it’s a good time to explain how bonds and bond pricing work, as although they seem simple in concept, their operation can be a bit confusing.
Face value, coupon, yield
Say for example ABC Corp. issues a bond to raise some money for a new factory. The bond issue would be for a set sum, say GBP50m and is marketed with an interest rate of 2% per annum and a maturity, in this example 5 years. The bond would also say how often interest was to be paid, in this example annually. The issue would be broken down into smaller chunks, say GBP1,000. This is the ‘face value’ of the bond. In the olden days, the physical voucher or note would have the interest rate – also known as the coupon – with the maturity date written on the front of it. Today this is recorded in the Bond Prospectus.
The coupon would be paid annually until maturity. So after one year the bond holder would expect GBP1000 x 2% interest = GBP1,020. Most bonds don’t compound interest, so in this case after five years, you’ll get GBP1,100 back from the borrower. Simple enough.
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The complication arises when an investor decides that they don’t want to hold that bond for the full five years. What then happens is that the face value (GBP1,000) changes due to the demand and supply in the market. Say for example, a year on from initially investing in ABC’s bond, XYZ Plc issues its own GBP50m five-year bond, but XYZ is paying interest of 4%.
The new benchmark interest rate for 5-year GBP Corporate Bonds becomes 4%. As it’s a better use of capital, the investor wants to own the 4% as opposed to 2% bond, and so they sell the 2% bond at less than its face value. The value of bonds go up and down depending on the value of the income that their coupon provides when compared to the wider market.
So if interest rates go up, the attractiveness of that 2% bond diminishes and the bond’s price drops to compensate for a less attractive return – or yield. The ‘yield’ is the bond’s coupon rate divided by its market price. Price and yield are inversely related and as the price of a bond goes up, its yield goes down.
In the same way, if interest rates fall, that 2% bond becomes increasingly attractive, and should interest rates fall below 2%, that bond’s face value will rise above GBP1,000 should the bondholder want to sell their bond on the secondary market.
Of course, barring bankruptcy, should the bondholder hold that GBP1,000 bond until maturity, they will get back their GBP1,000 plus 2% interest over five years. However, they might have missed out on better returns in the market should they have sold out before maturity.
Inflation and interest rate
That’s why 2022 was such a bad year for bonds. Prior to last year, interest rates in most of the developed economies were low and stable. But then inflation came along, and the only way that Central Banks seem to be able to combat inflation is by increasing interest rates. This meant that holders of five, 10-year or longer dated bonds were really missing out as interest rates spiked to the highest rate since the 1980s, which meant that the value of their bonds suffered.
Other factors also play into the price of bonds. For example, if the stock market rises, investors will dump bonds and move into equities, the same applies when the stock market falls – as investors seek out bonds as a safe haven. Bonds are often assigned credit ratings by agencies like Standard & Poor’s. The agencies track the economic health of issuers (companies or governments) and if the agencies conclude that the issuer’s economic prospects are in decline, they downgrade their ratings, which affects the price of the bond. Maturity also plays in – the closer the bond gets to maturity – the closer bond’s price moves towards its face value, or par.
Inflation is a bad, bad thing for bonds, and as at December 2022 the Investment Association’s UK Index Linked Gilts peer group was reporting a loss of more than 30% over 2022, making it the worst performer across all of the IA’s 60 investment sectors. As the year closed all bond funds were down over the year.
Revival
But now might be the time to reconsider bonds. Although higher interest rates are set to stay, inflation is cooling, so the frequency of interest rate rises that Central Banks have been imposing will start to slow, making the market a lot more predictable. As interest rates reach their peak the trade off between risk and return will improve. As a result of 2022, bond prices are a lot lower, so it has become a buyers’ market, and as the year progresses, bonds will start to pull towards par which will see prices appreciate.
But where to start? One fund we’ve been looking at at The Armchair Trader is the Invesco Tactical Bond Fund which was launched in 1st February 2010. The fund is managed by Stuart Edwards and Julien Eberhardt out of Henley-on-Thames. Edwards is pretty new to the fund, having been in the hot seat since August 2020, but has been on the scene for more than 25 years. Prior to joining Invesco Perpetual, Edwards was an economist at S&P until 2003.
Eberhardt joined the fund a year later but has been part of the Invesco fixed interest team since 2008 and both were instrumental in shaping the strategy for the investment manager’s fixed interest desk. The fund currently manages assets of more than GBP1bn and is a sterling-denominated ICVC (Investment Company with Variable Capital) structured as a UK-domiciled OEIC.
Flexibility and discipline
The fund has a disciplined investment process, but is quite goosey-loosey as to where it can invest – hence the ‘tactical’ moniker. The fund aims to achieve income and capital growth over the medium- to long-term (three-to-five-years or more) and invests through a flexible allocation to corporate and government debt securities, which may be investment grade, non-investment grade or have no credit rating and cash.
Tactically the fund can potentially be fully invested in cash and near cash instruments depending on market conditions, so it can protect itself from volatility in the bonds market and like most bond funds may use derivatives for investment purposes and to manage the fund more efficiently, with the aim of reducing risk, reducing costs and generating additional capital or income.
Edwards explained: “The fund has a flexible approach that aims to align risk and reward across bond markets as the opportunity set changes. This means that at times when we think that risk is not well rewarded the fund can hold large allocations to cash or cash equivalents. Equally, when we do think there is opportunity, we can quickly dial up the fund’s risk. This flexibility is central to the fund’s approach.”
The managers need to have a good take on the bigger economic picture, as they decide when to steam to port in the eventuality of an economic storm on the horizon and choose when to sally forth as the market recovers, so the allocation between cash, gilts and corporate bonds is key to the longer-term performance of the fund.
For comparison purposes, the fund is benchmarked against the UK Three Month Treasury Bills index, but given it’s tactical and flexible nature, will often track far from this index.
On an annualised basis, to end December 2022, the Invesco Tactical Bond fund returned 3.04% against the benchmark return of 0.6% over three-years. Over five years the fund returned 2.35% against a benchmark return of 0.6% and outperformed the index by 2.35% over 10-years, according to Invesco Perpetual.
Peer group outperformance
Cumulatively performance has been more variable. In the last six months, the fund returned 1.55% against a benchmark return of 1.3%. However, the fund underperformed over one year, returning -4.64% against a positive 1.65% return for the index. However, this should be considered in relation to the peer group, which on average lost over 11% in the same time period.
Over longer time periods the fund started to show its class. Over three years, the fund returned 9.4% against 1.9%, over five years the fund returned 12.3% against 3.2% for the index, and over 10 years the fund 32% against 4.8% for the benchmark.
According to Hargreaves Lansdown: “In recent months, the managers have added to investment grade corporate bonds, those with a credit rating of BBB or above. This included investing in new issues from household names McDonald’s, Nestle and John Deere. They currently view this as the most attractive area of the market.”
Emerging markets
The managers also increased exposure to emerging market debt, with around 7% of the fund invested in these bonds, according to the broker. During 2022 they added a position in Brazilian government debt and increased holdings in South African and Mexican debt too. They have sold high yield corporate bonds and lower rated bank bonds in order to make room for these increases. Duration has also been meaningfully adjusted during 2022, having started the year with a duration near zero and ending the year with a duration of around 3.5 years.
This fund has an ongoing annual charge of 0.75%. However, if investing through a platform the fund does offer a discount. For example through HL there is an ongoing saving of 0.25% which means that investors through the HL platform pay 0.5%. However, HL also charges a 0.45% platform fee.
At the end of January 2023, the fund’s top five holdings were:
| Rank | Largest holdings | % |
| 1 | UNITED KINGDOM GILT 0.250 JAN 31 25 REGS | 3.53 |
| 2 | UK TREASURY 1.250 JUL 22 27 | 3.20 |
| 3 | UNITED STATES TREAS 4.500 NOV 30 24 | 2.68 |
| 4 | INVESCO STERL LIQI PRTF-AGY | 2.58 |
| 5 | US TREASURY 0.125 JUN 30 23 | 2.25 |
Source: Trustnet
In terms of asset allocation, the company was distributed as follows:
| Rank | Asset | % |
| 1 | Investment Grade Corporate Bond | 41.07 |
| 2 | Investment Grade Government Bond | 25.80 |
| 3 | High Yield Corporate Bond | 20.18 |
| 4 | Cash | 7.50 |
Source: Trustnet
The investment management sector is championing the mantra: “Bonds are Back!” Although it might be too early to say this unequivocally, the asset class is worth a further look. Unless something leftfield emerges, it is safe to say that the bonds market will not see a year like 2022 again for a while.
With stock market performance expected to be disappointing this year, bonds may well reclaim the mantle of being an income-providing, safe-haven hedge against volatility and underperformance in the equity markets. If Central Banks have climbed down from DEFCON1 and can resist repeatedly hitting the rate rise button like it’s a strongman game at the funfair, bond prices will rise as the rate cycle cools and the asset class will become once again the classic defensive investment choice.
The Invesco Tactical Bond fund should reward investors with a long-term view, and in current market conditions hold its own, but start to lag other options as the market recovers. It’s early days for the sector, but the mood music implies that bonds may recover in 2023.
To use a bond manager joke:
“Q: Why did everyone fall asleep at the bond conference?”
“A: There was little or no interest.”
This might not be the case in 2023.
