How bonds works and why you should own some

Sam Benstead interviews Invesco Sterling Bond manager Michael Matthews about the role of fixed income (bonds) in portfolios.  

Matthews speaks about how bonds behave in different environments, how yields on bonds are calculated, and why bonds can be an excellent diversifier to equities. He also reveals how his fund is positioned today.  

Invesco Sterling Bond is one of ii’s Super 60 investment ideas.

• Invest with ii: Investing in Bonds | Free Regular Investing | Open a SIPP

Sam Benstead, fixed income lead, interactive investor: Hello and welcome to the latest Insider Interview. Our guest today is Michael Matthews, manager of the Invesco Sterling Bond Fund. Michael, thanks very much for coming into the studio.

Michael Matthews, manager of Invesco Sterling Bond fund: Morning.

Sam Benstead: Bonds can often be a tricky area for retail investors to understand. So, to start with, can you explain what bonds are and how they typically fit into portfolios?

Michael Matthews: I think bonds are much better known than when I first started. I started working in the fixed-income team in 1995, and I think then, actually even myself, I didn’t know what a bond was. I think most people thought of bonds, or when they were thinking about investing, they were thinking of cash or equities. People didn’t think about bonds.

In those days, you didn’t even have a European high-yield market. Bonds are essentially a tradable loan to either a government or to a corporation, where you have an agreed term when it’s issued and you’ll have either a fixed coupon or a floating rate.

With a government bond, you’ll have interest-rate risk. So, depending on what markets are doing, what central banks are doing, it will impact the interest-rate risks, and then you’ll also have credit risk. So, if you invest or lend to corporates, there’ll be a credit-risk component on the side of that.

Sam Benstead: How do different market conditions affect the prices of bonds?

Michael Matthews: Well, it depends on your risk appetite. So, as I just said, there’s two components. There’s the interest-rate risk or the credit risk, and there’s a huge risk spectrum on the credit risk.

So, you can have very risk-free. If they are risk-free these days, you can government bonds. Historically, they would have been at the upper end of the credit rating. So, all bonds that are issued will often have a credit rating by the rating agency. So, you start with AAA, which are considered to be very risk-free, and then you go down to AA, A, BBB, and that’s the investment-grade universe where the chance of default is very remote. Then you go into high yields at BB, B, CCC.

So, with a bond, if you’re looking at the governments or the very good-quality investment grade, a lot of the time you’re thinking about interest-rate risk, whether central banks are going to be cutting rates, whether duration is going to be working. If inflation is falling, then central banks will often be cutting and then there’s a chance if rates are being cut, bond prices will often be going up because yields will be falling, so you want some duration risk or interest-rate risk in the portfolio.

If you’re thinking about more like equities on the credit side, if economies are doing well and spreads are wide and you think credit quality is going to improve, then you want more credit risk in the portfolio, where you get a bit more yield over the risk-free.

What we had in more recent times when inflation has been picking up, you’d be much better off in the credit-risk component than in the interest-rate risk component. But really, for investors, you’ve got to be thinking about the two.

For a diversified portfolio, quite often having some interest-rate risk in the portfolio, in normal markets, would not be correlated with equity risk or credit risk. So, if you have a risk-off period, or if the economy is starting to weaken, then the interest component or the government bond side, could probably make you money when equities are losing you money.

• Bonds bolster portfolios amid equity collapse
• Bond Watch: Trump’s trade war could boost UK bonds

Sam Benstead: What bonds go into your portfolio, and what opportunities are you finding today?

Michael Matthews: Well, our portfolio has a pretty broad remit. It’s a flexible sterling investment-grade (IG) portfolio. It has to be 70% in IG, and we try to change the structure of the portfolio, depending on our view of markets.

At the moment, credit spreads are pretty tight. I think sterling investment-grade credit spreads are about 100 basis points and I think over the last 20 years they probably average around 150, 160. Probably broadly speaking, we think of credit spreads for investment grade as being between 100 and 200 basis points. So, you want to be buying them at the wide end and having less when they are tight. But all-in yields are relatively attractive because risk-free rates are high.

So, gilt yields at the moment, depending where you are on the curve, vary between 4.25% and 5.25%. So, if you go to the longer end of the UK curve, it gives you 5.25%, and add on a bit of a credit spread. You can add quite a nice yield to a portfolio without taking too much credit risk.

This hasn’t necessarily worked that well in recent times, because as I said, credit risk, equity risk, has been doing better. But I think now you can get yields that historically aren’t that dissimilar to what you’d get in AT1 or high yield without taking too much credit risk, but you are taking duration risk.

So, actually the portfolio is as defensively positioned as it has been. The 70% we have to be invested in IG credit, and this 30% risk bucket, quite often we would use it to have high yield or AT1s. At the moment, we’re using it to have cash or governments to have the portfolio a bit more de-risked.

Sam Benstead: What’s the yield on the fund at the moment? And can you explain the different types of yields that someone might find on a factsheet?

Michael Matthews: Depending on whether you’re looking at running yield or redemption yield, I think the running yield is probably just over 4% and the redemption yield is about 5.25%. Probably some of the listeners will be thinking: what’s the difference? With a running yield, it purely is the coupon divided by the price. Obviously we’ve been through a relatively challenging period for fixed income and a lot of the bonds that were issued five, six, seven years ago are now trading at a discount to a par. So, the redemption yield will be higher because you’ll have some capital gain.

So, let’s say a 4% bond trading at 80p, the flat yield would just be the income divided price, which would give you a yield of 5%. The redemption yield, you would capture the discount to par, so the 20 points between the 80 and 100, you get redemption. Let’s say it’s a 10-year bond, you then get an additional two points per year. I’m giving you it in simplistic terms because there’s actually a present value of cash flow, so it’s not exactly that, but redemption yield. I think for most bond funds at the moment, when you’re looking at them, the redemption yield will be higher because lots of the funds, individual bonds, are at a lower price. I think, for our fund, the average bond price is probably around 90 at the moment.

• Benstead on Bonds: in a worst-case scenario, can gilts deliver?
• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis

Sam Benstead: It’s the Invesco Sterling Bond fund, but can you invest internationally as well? And do you?

Michael Matthews: We’re having this interview at probably not the best time for me to be banging the table telling you about all the exciting things that we’re doing. So, it has to be hedged back to sterling, and it has to be 70% investment grade. Other than that, the fund has a lot of flexibility.

So, if we were having this conversation a few years ago, we’d probably be talking about the allocation to US credit that we had. Actually, maybe if we went back to probably 2019, 2020, 2021, actually, we could go back to the Brexit vote, we had quite low levels of UK interest-rate risk because gilt yields were very low, the lowest, not as low as bonds, but gilts were very relatively low. And we were adding US dollar bonds because they were yielding higher, it’s a more liquid market. You could pick up a bit of yield, and you had more liquidity. Then we were hedging the currency back, and we were doing the same in euros.

Most of the sterling market is international issuers. We don’t look at UK-based companies. At the moment, we have a fund that’s purely in sterling credit, but it is still from global issuers.

Sam Benstead: What are the advantages of owning a bond fund like yours over owning gilts directly, which is something we’ve seen as a very popular theme at the moment among our customers?

Michael Matthews: I know lots of people are looking at gilts, especially for the low cash price bonds, where there’s a tax advantage for some people outside of a tax wrapper. But for an investor looking at the sterling bond fund, I think the advantage you get, one is that we have credit risk in the portfolio, so you’re getting that additional yield for having the corporate risk rather than having the gilt risk.

I think looking back, it’s been a challenging period for active fixed-income managers versus passive. But as we’re going into a more challenging environment, I think active management, where we manage the duration risk and the credit risk through the cycle, so at the moment, as we were just discussing, the portfolio is de-risked because we think credit spreads are relatively tight. But we’ve got a bit of duration because we think duration is giving us a bit a yield.

If you were just buying an individual bond or a gilt, you don’t have someone taking that active view on whether now is the right time. If you’re buying and holding it to maturity, you know what you’re getting now, whether it’s a good entry point or not. I think for us, we’re very focused on whether we’re getting paid to take the risk.

Really, what we want to be doing in an ideal world is to be buying bonds when spreads are wide, you’re getting overcompensated for the risk you’re taking, but the market’s quite nervous about the risk. Then, in a more benign backdrop, the spreads can tighten back in.

I think what investors get when they’re buying the sterling bond fund, if you look back, I know you’re probably not allowed to say it, but if you look back at history as being the guide, we’ve had a good record of buying when spreads are wide, but also at the same time, being de-risked when we think spreads are tight. So, you’re getting someone that actively manages the portfolio for you.

Sam Benstead: Michael, thanks very much for coming in.

Michael Matthews: Thank you.

Sam Benstead: And that’s all we’ve got time for today. You can check out more Insider Interviews on our YouTube channel, where you can like, comment, and subscribe. See you next time.