Benstead on Bonds: where to find the best yields in 2023

Higher interest rates mean bonds make sense again – but which funds are worth considering? 

Any remotely interested follower of financial markets and the financial press will know that interest rates – and therefore bonds yields – have risen dramatically.

“Bonds are back” is the mantra of nearly all investment houses as the new year begins, with fund managers in unison claiming that there is finally an alternative to stocks.

Bryn Jones, fixed income director at fund group Rathbones, says that TINA (there is no alternative) has been replaced by TANIA: “there are now investment alternatives”.

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It is one of the reasons for the launch of this column: to help investors tap into higher yields, understand the dynamics of bond markets, and effectively manage their own money.

Let’s look at the changes in bond yields compared with just a year ago, driven by the Bank of England first raising interest rates from 0.1% to 0.25% in December 2021, and then gradually increasing them until they reached 3.5% last month.

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In the US, the Federal Reserve has jacked up rates from 0.25% just over a year ago to 4.5% today. Central banks have taken such extreme measures to combat inflation, which is currently at 10% in Britain and 8.5% in the US.

Investors buying 10-year gilts (debt issued by the UK government), can lock in 3.2% annual returns, as of 25 January 2023. The yield was 1.2% this time last year. Investors saw a similar move in US 10-year Treasury yields, which have risen from 1.8% to 3.5%.

Rising yields from the safest bonds has a knock-on effect for riskier bonds, with yields on debt issued by companies, or less stable governments, also shooting up over the past year.

Which bond sectors yield the most? 

With inflation still at double digits in the UK, but falling slowly, investors will struggle to get an inflation-beating income. But there are plenty of options that provide respectable returns without many of the risks of the stock market, and if inflation falls back to the 2% target then real returns will become more attractive.

These are the yields of the key sterling bond sectors, according to data from FE FundInfo and the Investment Association’s fund groups.

I took the average of the yields from the data that was available, so there are some funds missing, but it is a good indication of what is available as income to investors, generally paid quarterly although some funds make monthly distributions.

Source: FE FundInfo and interactive investor, 25 January 2023.

The higher the yield, the greater the risk, as investors demand a higher return on their investment. This is clear in the data, with high-yield bonds paying investors the most and gilts paying the least. Strategic bond funds take a go-anywhere approach and build portfolios of all different types of bonds to reduce risk and increase opportunity.

Note that the current yield is different to the yield to maturity, which includes the return of an investor’s principle. This is why UK gilts bought individually yield more than 3%, but gilt funds are paying out less as income.

These fund sectors include hundreds of strategies, but fortunately interactive investor has its Super 60 and ACE 40 investment ideas, where our expert fund research team pick out their favourite stock and bond market funds. The bond funds include emerging market, sustainable, and global and sterling bond options.

Dzmitry Lipski, head of funds research at interactive investor, selects funds that are suitable for all investors, with strong track records and management. They are selected without commercial incentives and from a range of investment sectors.

The funds with the highest yields are Royal London Sterling Extra Yield Bond (6.55%); Royal London Global Bond Opportunities (6.5%); and M&G Emerging Markets Bond (5.77%), according to FE FundInfo. These are the bond funds on the lists and their yields, as of January 2023.

The highest-yielding Super 60 and ACE 40 bond funds

Source: FE FundInfo, fund factsheets, 26 January 2023. Past performance is not a guide to future performance.

Where to invest in 2023

So if higher yields mean more risk, what is the right balance between risk and return this year? PGIM Fixed Income, which overseas $770 billion (£622 billion) in assets, thinks that emerging markets bonds are a good bet this year.

It says that because inflation is easing, the US Federal Reserve may be nearing its peak interest rate, which could spell the end of the dollar’s strong rise over the past year. A weaker dollar is good for emerging market bonds, as they often pay investors in dollars via “hard currency” debt.

PGIM Fixed Income is also “incrementally constructive” on global investment-grade bonds. Investment-grade corporate bonds or development market bonds, where the risk of default is low are typically a good bet during difficult economies.

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Alongside steady income payments, their defensive characteristics could also lead to capital appreciation, which is good for an investor’s total return. With peak interest rates forecast for the first quarter of 2023 and the possibility of rate cuts later in the year, this is also a tailwind for fixed income generally.

Lipski says developed government and high-quality corporate bonds should continue to offer investors the benefits of diversification away from equities, along with stable income and relatively low volatility especially in periods of economic uncertainty and recession.

He says Jupiter Strategic Bond, a Super 60 fund, is a strong option in the current environment. “It is a ‘go anywhere,’ high-conviction fund, meaning the managers are able to seek out the best opportunities within the fixed-interest universe on a global basis, while carefully managing downside risk.”

Emerging market opportunity

Lipski also likes emerging market bonds, where he says valuations are now attractive after a big sell-off last year following Russia’s invasion of Ukraine.

He said: “With spreads widening and yields rising, valuations started to look attractive, making it a good buying opportunity for long-term investors."

My bond market tip for 2023 was the M&G Emerging Market Bond fund, a Super 60 member. I’m backing emerging market rather than developed market bonds because the starting yields are far higher, and if bond prices keep rising, then emerging market bonds could be some of the biggest winners.

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This fund is paying out around 6% each month to investors, but that distribution yield should rise as it adds new, higher-yielding bonds to the portfolio. 

Thomas Becket, chief investment officer at Canaccord Genuity, a wealth manager, is also positive on emerging markets: “Yields are attractive, the bonds trade below their issue (or par) value, and the chance of default is low,” he says.

He also says that corporate bonds paying dividends in sterling look attractive. Client portfolios own Invesco Sterling Bond fund, which yields 4.5%.

“Bonds are a good bet because globally economic growth is set to slow. You can now get 6% yields, when accounting for the return of the bond principal, from investment-grade UK bonds. There is finally an alternative to stocks, which still look expensive.”