Why are investors buying bond funds again?

Concerns equities have run their course after the strong rally since the end of March is one of the drivers behind investors boosting exposure to bond funds.  

Bond funds are back on investors’ shopping lists once more, according to the latest fund sales figures from the Investment Association. 

In July, retail investors ploughed a net £1.8 billion into bond funds, in contrast to equity funds which saw £609 million of withdrawals as investors sold UK equity funds in particular.

Global Bond was the best-selling sector for the month, attracting £693 million, followed by £ Corporate Bond, which enjoyed £691 million in net retail sales.

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"Bond funds took pole position [in July], with net retail sales close to £2 billion for the third consecutive month as investors sought out new sources of income,” says Chris Cummings, chief executive of the Investment Association.

Dividends under pressure

The hunt for income is likely to be a key driver of investors’ renewed focus on bonds. Companies across the marketplace have taken the axe to dividends in the face of Covid-19 pressures, forcing equity income investors to look elsewhere for more reliable sources of yield.

But could bond fund buying also be a signal that investors are expecting a fresh equity market sell-off, perhaps driven by a coronavirus ‘second wave’?

Eduardo Sánchez, senior investment research analyst at Square Mile, says there are a number of concerns shaping investors’ decisions.

“Some investors are evidently of the opinion that equities have run their course after the strong rally since the end of March,” he says.

“When thinking of investing for income in particular, equities look a poor investment in the near term with many companies having now cancelled or suspended dividend payments in response to the pandemic.” He notes that while in some cases this is because companies can’t afford the payouts in the face of falling revenues, in others it is because regulators have forced them to freeze distributions. In either case, the net impact on investors is that yield is harder to find. 

In contrast to equities, “the issuers of corporate bonds have a contractual obligation to pay their coupon,” Sánchez explains. So, “despite their reduced profitability sparked by the economic contraction, companies will keep up their bond payments, barring the case of default.”

Meanwhile, corporate bonds look much more attractive when set against the negative yields available on some government bonds, meaning investors are essentially paying to park their cash there. 

“Income investors could also do better than turning to government bonds, as, in an attempt to support economic growth, central banks have increasingly lowered interest rates, increasing the amount of debt globally that pays negative yields. As such, investors searching for income are increasing the demand for credit as a source of positive income for their portfolios,” he says.

Investor cash looks for a home

After the market recovery following February to March’s sell-off, investors are putting money back into the market and this money is looking for a home. Morningstar portfolio manager Mark Preskett explains that moderate balanced portfolios are always a popular choice among financial advisers, for example, those with a 60%/40% split in bonds and equities. This means that, if people are putting money back into the market, the majority will be going into bonds. 

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Preskett points out that spreads (the difference in yield between a corporate bond and similar duration government bond) are reasonable right now, and investors are also benefiting from “quite significant central bank support” as these institutions buy up large swathes of corporate bonds. 

He adds: “The Bank of Japan, the European Central Bank, the Federal Reserve and the Bank of England are all buying corporate bonds as part of their quantitative easing programmes and that's been quite a significant driver of their returns and the narrowing of those spreads. The difference in yield has been coming down as corporate bond prices appreciate so it's been a good place to be invested since March.”

Preskett says Morningstar data shows that popular global bond funds in July included the Vanguard Global Bond Index tracker, which took £343 million in that month alone. The GBP hedged share class version of the passively managed fund is one of interactive investor’s Super 60 choices. 

There were also flows of around £60 million to £80 million into corporate bond funds including Royal London Sterling Credit, JPM Sterling Corporate Bond and Merian Corporate Bond.