Investing in bonds to beat inflation

Why there is always a place for bonds

High inflation means interest rate rises and this in turn makes bond values fall, so they might not seem the ideal place to look for investment opportunities. So why might now be exactly the right time to increase your bond exposure? For the answer, we turned to Mark Holman of TwentyFour Asset Management.

Mark has been a bond fund manager for 34 years, and he believes there is always going to be a role for bonds in an investment portfolio.

A change in direction

In general, when you are looking for bonds to provide protection and counterbalance the risk of equities, government bonds can be used as a risk-off* investment. They are normally perceived as lower risk than equities and the prices tend to move in opposite directions.

With the recent sharp increases in inflation, the usual dynamic of falls in equity markets being offset by rises in government bond prices has not held true so far in 2022. The Financial Times Stock Exchange (FTSE) UK Gilts Index (an index of British government securities) fell more than 14% in the first half of 2022, while the FTSE All-Share Index (which tracks around 600 companies traded on the London Stock Exchange) fell less than 5%.

However, bond investing can also be used in a risk-on manner*, by taking credit-risk** to achieve higher returns. These two approaches can be blended at different points in the economic cycle to optimise returns from bonds.

*‘Risk-on/risk-off’ refers to investors’ investment patterns in response to the perceived level of economic and market risk. When risk is seen as high, investors tend to move in to lower-risk, or ‘risk-off’ investments such as government bonds or cash. If investors anticipate that taking a higher risk will lead to a higher reward, they tend to move in to higher-risk instruments; for example, moving from investing in government bonds to equities.

**Credit risk refers to the probability of loss in the event that a borrower fails to make payments on a debt.

When ‘sensible’ makes sense

Mark currently sees conditions as very favourable for a risk-on bond investment style. However, this is not to propose taking a high level of risk in underlying investment instruments. The very rapid repricing of bonds in response to the current economic conditions has made a lot of bonds look very attractive in terms of their valuation, where bonds of ‘sensible’ companies are trading at prices well below the bond’s maturity value.

Mark sees an opportunity to take advantage of these attractive valuations, as investing now means that the coupon paid by the bond will be boosted by a notable capital uplift at maturity. He expects this to lead to the potential for equity-like returns, if a carefully researched set of corporate bond assets is selected.

Key characteristics to look for are:

• Bonds that are relatively short-dated, so the time horizon for receiving the full redemption value of the bond is not far away
• Companies with a low likelihood of defaulting
• Companies with pricing power, offering products or services that consumers can still afford.

Bond investment opportunities

In terms of opportunities, he says that it is good to look for these globally. For example, the EU may have very significant energy problems to navigate, but that has been aggressively priced in to European bonds. It is also key to look across the different industry sectors for the best opportunities.

Mark currently sees banks as an interesting area. Banks have rebuilt their capital to what he believes is an extreme level, many times the levels before the financial crisis in 2008/2009. When you have a contingent convertible bond issued by the likes of Barclays, that will only be ‘converted’ in the highly unlikely event that Barclays’ capital levels fell below its regulatory requirements, yielding over 10%, that creates a clear opportunity.

Dedicated bond investment expertise

With economic weakness, investors should expect higher default levels on bonds, so it’s important to do your research carefully. At Canaccord Genuity Wealth Management we base our decisions on the expertise of dedicated bond investment teams, such as those at TwentyFour Asset Management, when we invest our discretionary clients’ money in bond funds.

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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.

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