Income-seeking fund investors back bonds over shares

Bond funds are becoming more popular and various experts have tipped the asset class to be a winner in 2023. Kyle Caldwell explains why, and considers the pros and cons.

Fund investors have been moving to take advantage of bond yields being at their most attractive levels in several years.

The latest fund flow figures from the Investment Association (IA), covering the month of November 2022, show that bond funds attracted £1.3 billion. In contrast, more money was withdrawn than invested in equity funds, which registered outflows of £486 million. Overall, the bond-buying spree pushed overall fund sales into positive territory, at £389 million. This was the first time in six months that funds posted inflows.

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The most-popular bond sectors, in second, third and fourth place in the rankings, were corporate bond, sterling corporate bond and global inflation-linked bond.

However, topping the sales table for November was equity fund sector North America. Given the notable underperformance of US indices in 2022, the move to increase exposure is an attempt by investors to “buy low” in the hope that 2023 is a more prosperous year.

In contrast, investors are less positive on other developed market equity regions. This is reflected by outflows of £1.1 billon and £834 million for UK and European equity funds.

The move to increase exposure to bonds comes at a time when various commentators have tipped the asset class to bounce back in 2023.

Fixed income had a poor year in 2022, with some bond funds positing double-digit losses, in response to interest rate rises.

However, with interest rates close to peaking and bond yields at much higher levels than a year ago, the asset class has become more attractive. Various professional investors also expect bonds to regain their role as defensive ballast in portfolios in being less correlated to equities.

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An investment sentiment survey by Asset Risk Consultants (ARC) found that wealth managers are the most bullish on bonds since the aftermath of the global financial crisis in 2009.

Graham Harrison, chair of the ARC, says: “For the first time in over a decade investors need to be paying close attention to the amount of money they invest in bonds alongside the shares they hold in companies. For more than 10 years, investing in bonds has given very little yield or interest income — this has now changed. Bonds are back and subsequently, so is the traditional balanced portfolio.”

Inflation is the key to market performance in 2023, particularly for bonds. If inflation remains stubbornly high, then the likelihood is there will be further interest rate rises. When rates rise, bond prices fall and yields rise, with long-duration bonds the most impacted.  

Johanna Kyrklund, Schroders’ group chief investment officer and co-head of investment, says:“Provided inflation does come down, we could start to see a more benign environment for markets. But if inflation persists, then we've got a problem on our hands. Rates might then have to go even higher, and markets would have to reassess valuations once again.

“However, compared to the volatility of 2022, we expect interest rates, and therefore fixed income, to be more stable in 2023, allowing investors to take advantage of the yields on offer. Indeed, the appeal of bonds has changed from being their diversification benefits, to their yields.”

Equities vs bonds, which is best for income seekers?

Rather than an either or choice, it is prudent for investors to have exposure to both asset classes in a portfolio to reduce risk by having diversification. One popular strategy is 60/40, holding 60% in shares and 40% in bonds.

However, in terms of which of the two asset classes offers income-seeking investors better value at this moment in time, views among the pros vary. 

The income that bonds pay, which is fixed and therefore more reliable than dividends promised by equities, is a key attraction for investors, according to Duncan MacInnes, fund manager of Ruffer Investment Company (LSE:RICA).

In an interview with interactive investor last month, MacInnes said bonds are offering investors better value than equities from an income perspective “because they are safer”.

He added: “So, 4% in a government bond is a safer income prospect than a 5% dividend yield, of course. In fact, that’s something that has really struck me this year, that the equity risk premium - which is, perhaps, a little bit too technical, but basically the earnings yield of the markets minus the government bond yield - has come down.

“Now, given the deteriorating market environment, the deteriorating liquidity environment, the economic outlook, and the geopolitical outlook, I think the equity risk premium should be significantly wider, not narrower. So definitely the risks that we have been reintroducing into the portfolio have all been via the bond market...because we think interest rates might have peaked and might come down, rather than diving into the equity market.”

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However, while equities are higher risk, there’s the prospect of higher rewards over the long term, and benefiting from capital growth as well as dividend returns. In contrast, the income  on bonds is fixed, meaning there’s no possibility of a higher return.

Gervais Williams, fund manager of Diverse Income Trust (LSE:DIVI), argues that inflation will prove to be a long-term problem. Due to this, he says that: “The disadvantage of fixed income, of course, is that [its] fixed income. When you’ve got inflation, [bonds] don’t go up with inflation.”

Williams added: “The great advantage of investing in companies is that their sales tend to rise with inflation, which means that their income, if they continue to exceed, rises. It’s the good and growing income that we believe is going to become not just attractive now, but going forward.”