Record amount exits equity funds, with investors favouring bonds

Investors remain cautious on equity markets, but have turned positive on bonds. Kyle Caldwell explains why.

A record amount of investor withdrawals were made from equity funds in August, the latest figures from the Investment Association (IA) show.

Almost £3 billion was pulled, which is the highest monthly outflow on record. This was heavily influenced by UK equity and global equity funds proving unpopular, with £1 billion and £828 million withdrawn respectively.

Overall, investors took £2.6 billion out of funds, which marks the seventh month of outflows this year. Year-to-date, £14.6 billion has been withdrawn.

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Bond funds, however, bucked the wider trend. In August, £1 billion was invested. Strategic bond funds were the most-popular bond sector, attracting £288 million.

Such funds can mix and match any type of bond, such as government bonds, investment-grade corporate bonds and high-yield bonds. In theory, the bond pros running these funds can steer their portfolios to the best bonds to profit from the macroeconomic backdrop. Funds in this sector also have the ability to select the best bonds to protect and profit from interest rate rises.

Other bond funds are more constrained in that they can invest only in a specific part of the bond market.

In interactive investor’s Super 60 list of investment ideas, flexible bond options include the M&G Global Macro Bond and Jupiter Strategic Bond.

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The increased demand for bonds is also mirrored among interactive investor customers. Since the UK government’s mini-budget last month, there’s been a significant uptick of purchases of gilts with short lifespans (five years or less). Buying bonds directly, rather than via a bond fund, means investors get the full benefit of rising yields.

In 2022, bond yields have risen notably and bond prices have fallen significantly in response to interest rate rises. For example, over the past year, the yield on 10-year UK government bonds has risen from 1.08% to 4.22%.

In contrast, buying bond funds means investors get a slice of a basket of bonds that were highly likely to have been bought at lower yields by a fund manager. While this is a more diversified approach to bond investing, and the fund manager will be adding higher-yielding bonds to the portfolio, a fund’s ‘distribution’ yield will lag the yield available on similar direct bonds. Therefore, buying bonds directly and holding them to maturity can be a more effective way for sophisticated investors to profit from the spike in yields.

The latest predictions are that interest rates could more than double by next spring to around 5.5%, up from the current 2.25%. In the short run, rising interest rates are a headwind for bonds. However, rising interest rates can be beneficial for new investors as it offers them the chance to pick up higher yields.