Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Unless you’re a regular FT reader, the biggest story you won’t have read about in most newspapers in the past few weeks has been the remorseless rise in yields on US government bonds with maturities of 10 years or more.
The crucial US 10-year yield has breezed past 5 per cent as investors have sold over fears that inflation might stay higher in a world drowning in government debt funding. It’s the first time we’ve seen a yield that high since 2007.
There are lots of factors at work here, but most observers argue that the chief culprit is a “higher for longer” narrative, which suggests both interest rates (above 5 per cent) and inflation rates (in a range between 3 and 6 per cent) will remain elevated.
The pain has been most acute for longer-maturity government bonds because these are the most sensitive to changing expectations of long-term inflation (and rates). But I’m firmly in the camp that says we are fast approaching peak rates and thus fixed income securities are starting to look attractive again — after their recent massive sell-off.
It’s certainly the case that many investors are beginning to buy relatively low-risk government securities at the moment. Wealth advisers such as Killik and Co have capitalised on this shift in sentiment by launching services such as its Gilt Saver Service, a managed portfolio of directly held bonds that aims to provide a predictable level of income while maintaining a low volatility of capital. It invests in short-dated UK government bonds (gilts), bills, supranational bonds and short-dated bonds issued by government-guaranteed organisations. Unlike a fund — and like its existing short-duration bonds service — it consists of an actual portfolio of your own bonds.
I’m firmly in the camp that says we are fast approaching peak rates and thus fixed income securities are starting to look attractive again — after their recent massive sell-off
On the spectrum of risk, this is at the lower end, although it’s not entirely risk free if interest rates keep going higher. But there are plenty of more adventurous options for those prepared to move further up the duration curve.
Take an exchange traded fund from iShares called the USD Treasury Bond 20+yr UCITS ETF GBP Hedged (Distributing version), with a ticker IDTG. This is a tracker fund (hedged against the dollar) which is a way of buying that long end of the US government bond curve in an ETF format.
In recent years this fund has been an absolutely terrible investment as yields have gone up and prices fell. However, if you think that at some point the direction of travel will be lower yields, this is ideally positioned to benefit. Its weighted average yield to maturity currently runs at just under 5 per cent.
Sticking with US government bonds, long-dated index-linked bonds are worth a look, with yields in real terms of 1.5 per cent (or more). These can come with very high levels of volatility, though, with a price movement greater than bitcoin over the past couple of years.
For adventurers there’s also UK gilt UKT0.5 per cent 2061. This is currently priced at £25.15 between the bid and offer price and yields 4.8 per cent. One bond market expert I know reckons that if yields fall to 4 per cent in the next few years, the price of this bond could rise to £32, plus you’d pick up that yield. But beware if yields carry on rising. This is a widow-maker trade!
In the land of corporate bonds, a particular niche within the fixed-income world will at some point become very attractive — “fallen angel” bonds. These are corporate bonds issued by largish corporates that were once investment grade in risk but have been downgraded to a riskier category, usually junk. These downgrades are for all sorts of reasons, but usually because of a deterioration in trading that worries the rating agencies, which in turn leads many institutions to sell the bonds in a panic.
Bond funds pick up these funds on the presumption that the corporates have been shocked by their downgrade and many work hard to regain their creditworthiness. There are quite a few fallen angel ETFs in the market. One of the biggest is from iShares with the ticker WIGG. This slumped by 13 per cent in value in 2022, but is up 2 per cent so far this year and has a yield to maturity of around 8.25 per cent. Note that the underlying assets are dollar-denominated.
When it comes to retail bonds on the London Stock Exchange, there are some interesting riskier UK bonds deserving attention. I’d highlight two. First, the shorter-dated retail bond from fintech LendInvest, which pays 11.5 per cent through to 2026. Investors have security over a portfolio of residential property loans (largely shorter-term bridging debt). Second up is the Regional Reit retail bond, which pays 4.5 per cent to 2024. This bond is due for repayment next year and at a price of £93 carries a yield to maturity of 14.2 per cent.
Investors might also take a closer look at a couple of London-listed income funds that have a great record. The more conventional choice is the CQS New City High Yield bonds fund. With a market cap of over £250mn, it is one of the few investment trusts on the London market that trades at a premium — 4.7 per cent — and has a fund yield of 9.3 per cent. It invests in higher-yielding corporate paper and some funds.
For the really adventurous among you, Fair Oaks Income 2021 fund might be worth a closer look. This invests in US and European collateralised loan obligations (CLOs). This is a strongly US-denominated market and is usually the preserve of big institutions and hedge funds looking to invest in a pool of debt (corporate loans by issuers with lower credit ratings).
If rates go even higher we should expect corporate defaults to intensify. This could be a nightmare for the CLO market — and Fair Oaks — but it has an impressive record to date and seems to have avoided some of the recent blow-ups in this space. If rates start to head down again, this fund could be in a sweet spot. It currently trades at a 9.6 per cent discount with a fund yield of 14.7 per cent.