Bonds may have sold off but don't sell out
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While the outlook is mixed for bond prices, bond funds still have an important role to play in investors' portfolios, according to Morningstar.
One of the quickest trades that followed the 8 November election victory of Donald Trump was the selling out of bond funds, with investors piling into stocks as investors took on more risk with the promise of greater US growth.
In Australia, 10-year bond yields rose from a record low 1.82 per cent in August to as high as 2.67 per cent last week.
Economists predict bond prices could fall further as interest rates, economic growth and inflation potentially push higher as the US embarks on an economic growth splurge, or at least attempts such a run, through a massive infrastructure spending program.
The rotation out of bonds and into equities will potentially leave those left holding bonds at a loss if yields keep on rising. So, should investors still be invested bond funds or bond ETFs, or stick to cash? What are the risks they face and what are the benefits of bond funds?
Bonds typically pay fixed coupons, so investors will still receive a return, even with the capital loss from increasing rates. That's the good news.
But whether bond prices fall depends on how interest-rate sensitive they are, a characteristic called duration. The longer the term of the bond, the more interest-rate sensitive it is.
Tim Wong, a senior research analyst with Morningstar, says while the outlook is mixed for bond prices, bond funds still have an important role to play in investors' portfolios.
"Certainly, we would continue to encourage investors to have an allocation, or consider an allocation, to bond funds," he says.
"We would caution investors against removing their bond investment on the basis of one possible economic scenario, as we continue to believe in the role that high-grade bonds with interest-rate duration can play in a broader portfolio.
"High-grade bonds can help to diversify any portfolio with an exposure to risky assets such as equities or property. Concerns about economic growth or market volatility often coincide with falling interest rates. It's in these times that bond funds can provide a buffer for the broader portfolio.
"But certainly, bonds won't be performing at their best should the prospects of the end of ultra-low interest-rate policies and higher inflation in the US following the Trump victory materialise."
Having said that, corporate credit funds may not do as badly as those with a larger allocation to government bonds if interest rates rise.
Many actively managed credit funds are not as sensitive to changes in interest rates as government bonds given the way they are structured.
"Since the Trump victory, corporate credit spreads haven't really widened too significantly. While individual corporate bonds possess some duration, many actively managed credit funds are set up to limit this risk factor at the portfolio level, so they could be able to show a degree of stability even if rates rise," Wong says.
Wong cites the highly-rated Macquarie Income Opportunities Fund , which has a Silver rating from Morningstar and invests in largely Australian investment-grade debt and has a small allocation to cash.
Another highly rated fund is the Bentham Global Income Fund , which also has a Silver rating from Morningstar. This fund offers a slightly higher yield to maturity of about 6.5 per cent as it is exposed to higher-yielding and riskier credit securities.
The Schroders Credit Securities Fund , rated Bronze by Morningstar, like the Macquarie Income Opportunities has a high exposure to investment-grade debt. The fund seeks diversity by investing across the corporate capital structure, geographically and across the credit ratings spectrum.
"Meanwhile, there are several passively managed bond funds that can't adjust their portfolios to protect against rising bond yields. Still, these options are generally much cheaper than active funds, and there's no guarantee that interest rates will rise," Wong says.
Roger Bridges, global rates and currencies strategist with Nikko Asset Management, says traditional bond funds are usually made up of a pool of bonds with different maturity dates, with these funds always seeing coupons being paid, bonds maturing and proceeds being reinvested, often at higher rates [and lower bond prices].
"So even if a fund suffers losses such as we have seen recently, it's likely that these losses will fall over time, even if rates don't move higher," he says.
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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.
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