Benstead on Bonds: these pros have seen it all. Here’s what they’re buying today

After a series of false dawns, the fight against inflation seems be won. Central banks have pivoted, changing their tune from “higher for longer” to opening the door to interest rate cuts this year.

The Bank of England in February, after its rate decision, acknowledged that leaving interest rates at 5.25% would lead to inflation falling below its 2% consumer price index (CPI) target by the end of 2025, a price level which it says is “significantly” below its previous projections.

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Traders are betting that the Bank will cut rates four times this year, with the first one most likely coming in June, according to Bloomberg.

The possibility of interest rate cuts, combined with high yields on offer today (about 4% annualised if held to maturity from gilts and 5.5% from investment grade sterling corporate bonds), means that the outlook for fixed income is very positive.

In fact, fund group Schroders calculated that in the US, corporate bonds outperform inflation by six percentage points on average when the US central bank begins cutting interest rates.

Meanwhile, Vanguard expects UK bonds to deliver annualised returns of between 4.4% and 5.4% over the next decade, compared with the 0.8% to 1.8% in 10-year annualised returns it expected at the end of 2021, before the rate-hiking cycle began.

So, as the stars align for fixed income, where should you be looking to invest?

Buy bonds and ‘wait a year’

Stephen Snowden, head of fixed income at Artemis Fund Managers, says that interest rates are “simply out of step” with reality and will “have to fall from here”.

His Artemis Corporate Bond fund yields 5.4%, owning a portfolio of investment grade sterling corporate bonds.

He says buy bonds and forget about them for a year, as yields are higher than they have been for nearly a generation and bonds typically perform “very, very well” when the Bank of England starts cutting interest rates.

Snowden has been managing bond portfolios for 30 years and says that it is rare that bond managers bang the drum for their asset class. 

Recent activity includes participating in new issues from Thames Water, Barclays, and Coventry Building Society, all which he says have performed well, and buying longer-dated bonds before the December rally in bond prices.

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Jack Holmes, a bond portfolio manager also at Artemis, says high-yield bonds are worth looking at. High-yield bonds are higher risk than investment grade bonds and more vulnerable to changes in economic conditions, but greater income compensates investors.

Holmes says that high-yield bonds appear attractive under almost every scenario. 

He said: “If rates hover around their current levels, high-yield bonds can provide investors with attractive total returns. From November 2022 to November 2023, yields in the global high-yield bond market barely moved but a sterling investor would have made 8%.

“If there is an economic downturn or risk-off move, the high level of starting yields will help to offset any capital losses: yields would have to rise to well over 10% for investors to experience an outright loss. And if yields fall, there is the potential to make significant capital gains.”

What about gilts?

UK government bonds offer attractive yields and capital gains opportunities, according to Ian Williams, manager of the WS Charteris Strategic Bond fund. Williams has been working in the City for more than 40 years.

The 10-year gilt yields 3.8%, which is nearly double the rate on offer from German bonds. It is around the same as Italian bonds but higher than the roughly 3% on offer from Portuguese, French and Irish 10-year bonds.

Williams says: “We could see some sharp falls in US interest rates, and the Bank of England will eventually follow, but with a lag. There will be big capital gains on gilts when the Bank eventually cut.

“With the 10-year gilt around double the yield on the German 10-year bund, UK bonds are cheap relative to international bonds.”

He says that risk-averse investors could look at short-dated gilts, but Williams has been buying longer-dated gilts to benefit from capital appreciation. He switched his shorter gilts into longer ones in the first month of 2024.

“There is a good outlook for bonds right now and it is lining up to be a very positive six to nine months,” he said.

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Investors buying short-dated gilts, such as those maturing in less than five years, will see limited capital growth if there is a bond market rally.

Bryn Jones, who has been at the helm of the Rathbone Ethical Bond funds for more than 20 years, says: “If you're locking in yield at a sub-five year area and should interest rates fall, you're not going to benefit from the capital appreciation like you might do in a fund or a longer-duration asset.”

His corporate bond fund is overweight the insurance sector, which accounts for about 40% of his portfolio, and has a similar amount invested in bank bonds as well.

He says that these sectors are in a much better position financially than they were during the 2008 banking crisis, but yields are still very attractive on the bonds.

He said: “If you look at the Bank of England stress tests, they are really, really onerous and every single one of the UK banks is still a going concern with management action after some quite serious stress tests.

“So, as a bond investor where the capital is protected, we quite like the banks. And the same is true in the insurance sector. There's huge amounts of solvency. You take Rothesay Life, it has over 300% of excess solvency. And yet the bonds trade on a 12% or 13% yield. And therefore that's why we're overexposed to that area, because we think they are actually more defensive than what people think.”

US bonds also look interesting

Jim Leaviss, manager of the M&G Global Macro Bond fund, says 2024 could be the year of the bond, even though last year was positive for the asset class. Leaviss has been at M&G for more than 30 years and before that worked at the Bank of England.

He said: “2024 is really set up to a be a big one. The timing looks very interesting this year.”

His view is that when the Federal Reserve is about to start cutting interest rates, then this is the time to load up on bonds.

“We think the Federal Reserve is going to start cutting soon. They have told us they will cut at least three times. March this year will be eight months since the last rate hike and historically that is when you get the first cut.

“At some stage over a few months is when you are going to benefit from buying back into the US bond market.”

Leaviss adds that there are $8 trillion (£6.2 trillion) dollars in money market funds in the US. Cash waiting on the sidelines and FOMO – fear of missing out – is now kicking in as bonds and equities rally, he says.

“When yields fall, money market returns will also drop as well, which will push investors back into bonds and equities,” he said.