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Fund spotlight

21 December 2016

Hard-pressed income-seeking investors should consider investment grade bonds, writes Euan McNeil.

Lanterns on the beach

‘Gilt yields at all-time lows’ and ‘Negative interest rates in Europe’ were typical headlines through the summer. The Brexit result only served to drive yields lower and fixed income valuations to even greater extremes. Gilt investors are hugely challenged as current market pricing denies them the natural balance of diversification and income, historically associated with the gilt market. What should fixed income investors do? Firstly, it is important to recognise that we are in a structurally lower interest rate environment. Higher levels of both public and private sector debt combined with an ageing population and the hangover from the global financial crisis mean that interest rates are set to stay ‘lower for longer’. In market language, this is beginning to mean ‘lower forever’! For some years, markets had anticipated that the next UK base rate move would be up – not a cut from 0.5% to 0.25% as it transpired. It was only just over two years ago that 10 year gilts yielded 2.5%. Secondly, consider investment grade (IG) bonds. This category of bond has always offered higher yields than gilts, and in periods of lower volatility represents a relatively safe place to boost income from the bond market. IG companies – typically FTSE 100 issuers – are taking advantage of cheaper funding levels. Additionally, the Bank of England is set to support the market through its £10 billion corporate bond quantitative easing program. For the first time, the spread between corporate issuers and gilts represents almost two-thirds of the yield of the overall sterling IG universe. Whilst this had been driven by the rally in gilts, IG spreads are neither expensive historically nor look threatened by a step change in the global economic outlook. Since August, 10-year gilt yields have moved to a lower trading range of between 0.5% and 1%. Despite a likely increase in inflation, primarily driven by weaker sterling, gilt yields are set to stay at these lower levels. We, therefore, expect IG bonds to remain in favour, on the back of strong returns year-to-date and a current yield of 2.5%. Active strategies around duration ensure that funds can avoid pressures from any potential back-up in yields. Moreover, higher gilt yields tend to be associated with stronger economic growth – an environment in which IG spreads often prosper. Given the defensive qualities of IG bonds, any pull-back in equity markets should see them remaining well supported.

Euan McNeil is an investment manager in the fixed income team at Kames Capital.