John Baron: I'm buying bonds but being picky

Bonds were traditionally viewed as low risk but recent events and heightened volatility have shaken investors' belief that this is still the case. Investors have endured a difficult few years due to the rise in inflation and interest rates. Some are still wary. But interest rates having peaked and attractive yields are helping to stir interest in the sector. Prospects are now looking better. Risks remain but the coming shift in sentiment will prevail. The challenge now is for investors to ensure the right bonds are chosen as the disparity in returns within the sector may still surprise.

The pros and cons of bonds

In 2022, it was particularly challenging as the markets tried to anticipate the extent of central bank tightening when it was clear inflation was rising. However, the focus is now on the downward trajectory as inflation falls and the outlook has improved. Interest rates will remain higher for longer as central banks were behind the curve when inflation was rising and, aware of such criticism, they will be slow on the way down to ensure the inflation genie does not escape again. Policymakers’ credibility is at stake. But the direction of travel is set – and the bond markets sense it.

The road will not be a smooth one. Sentiment may be affected by the diverse forecasts for inflation, such as that between the Bank of England (BoE) and the Office for Budget Responsibility (OBR) – even for short-term outlooks. More government debt will weigh on prices. Concomitant to this, there is a further chance of the rating agencies downgrading bonds – as Fitch did last year to US government debt. Meanwhile, geo-political factors such as elections for half of the world’s population and continued regional tensions, could be a source of further uncertainty.

However, the shift in sentiment amid a changing trajectory for inflation will prove powerful. Even if inflation remains higher than before the spike over the long-term, as it will for reasons first cited in my column ‘Preparing for inflation’, one-off factors falling away in the short-term will ensure more immediate good news. The extent to which sentiment is shifting is perhaps illustrated by the OBR having recently halved its forecast for Q4 to 1.4 per cent from 2.8 per cent – even though the BoE is sticking with its 3.0 per cent forecast. The latter will catch up – a greater focus on leading indicators, such as money supply figures, would help. Meanwhile, let us hope unnecessarily high interest rates do not cause too much structural damage to the economy.

Whatever the extent of the portfolios’ bond exposure, it has always focused on higher-yielding corporate bonds. Government debt keeps rising, while corporate balance sheets remain robust – perhaps even more so recently. Higher-yielding bonds can also usually cope better with inflation volatility – having produced better total returns in 2022 and 2023 than either UK gilts or corporate bonds in general. Refinancing costs in a higher rate environment may be challenging for some leveraged companies, but default rates remain manageable despite the transition to sound money – helped by pessimistic forecasts about a recession proving wrong yet again.

Furthermore, experienced trust managers know the terrain and can often capitalise on the flexibility afforded by their remits. CVC Income & Growth (CVCG) exercises discretion in holding private debt for which the outlook looks more promising than it has for a while. CQS New City High Yield (NCYF) looks to equities and convertibles to help supplement its search for sustainable income generation. While Invesco Bond Income Plus (BIPS) has increased its exposure to financial corporate bonds given the yield-risk balance. Flexibility allows good managers to shine.

The portfolios also hold index-linked bonds. These have not performed well. However, exposure has been retained given an expectation that the market will come to realise inflation, while falling in the short-term, will settle over time at higher levels than previously thought. ‘Three plus’ may become the new ‘two’. This will not be sufficient to unduly trouble higher-yielding corporate bonds – but it may be different for gilts. No investment trusts focus exclusively on index-linked bonds, so the portfolios hold iShares Index Linked Gilts ETF (INXG).

The trusts I'm backing

Having reduced exposure to bonds a few years ago, where remits allow some of the 10 live investment trust portfolios managed on the website www.johnbaronportfolios.co.uk, including the two covered in this monthly column, have been increasing exposure of late. In addition to INXG, below are the portfolios’ key holdings.

CVCG provides exposure to high-yielding corporate bonds and debt, mostly within Europe. It has an excellent track courtesy of an extensive and experienced team of analysts. The company retains a defensive positioning focusing on larger, financially robust companies. This has helped the managers avoid some of the pain experienced by smaller businesses within the corporate debt sector. The company has significant exposure to floating rate debt which has proved helpful in funding special dividends – last year’s total dividend was 9.75p, including 7.5p for the ordinary dividend. The ordinary dividend target for this year is 8.2p, which equates to a yield of 7.6 per cent when bought.

NCYF seeks income by focusing on fixed-interest securities at the upper end of the yield curve, while supplementing this with exposure to largely high-yielding equities, convertibles and preference shares. The latter investments assist the company in maintaining its track record of modestly increasing dividends over time. The long-serving and respected manager, Ian ‘Franco’ Francis, has an excellent record of stewarding the company with total return performance being among the best in its peer group. Meanwhile, the 4.49p dividend equates to a yield of 8.6 per cent when bought.

BIPS seeks capital growth and income from high-yielding fixed-interest securities. The team believes the banking sector fundamentals are strong, with financials providing a more favourable risk-reward profile than similar-rated high yield bonds. As such, exposure has been gradually increased to subordinated bank and insurance bonds with the company now holding a diversified portfolio of c.20 European banks. This has been funded largely through reducing exposure to companies with weaker balance sheets. The managers have overseen a modest increase in dividends in recent years, courtesy in part because of a merger a few years ago. The 11.5p dividend equates to a yield of 6.7 per cent when bought.