This week’s warning by Kristin Forbes that her fellow members of the Bank of England’s monetary policy committee need to act sooner rather than later to head off inflation has fuelled fresh speculation that interest rates will start rising soon.
When that happens current bond yields will begin to look less attractive and bond prices are likely to fall. This will mean losses for the millions of UK investors who have turned to bond funds in their search for higher income.
So what should investors do? Times Money examines the options.
■ A wholesale sell-off
This is unlikely to be a practical option for most people because they have invested in bonds for income and still want that income, argues Adrian Lowcock, of AXA Wealth. He says: “If you do pull all your money out, there are only a limited number of alternative homes for it. ”
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He adds that it might be worth thinking about reducing your allocation to bonds, but not cutting it to zero. Although the capital value of your bonds is in danger of falling as interest rates rise, the yield on them is likely to remain quite healthy. At the same time it makes sense to consider reducing exposure to the most “at risk” sectors and seeking out bond fund managers who can make money in all types of market conditions.
■ Gilt funds
These are the most vulnerable to a rise in interest rates and could be one area to look to if you are wanting to prune your bond portfolio, says Juliet Schooling Latter, of Chelsea Financial Services.
Mr Lowcock is also wary of gilt funds. He expects medium and long-dated gilts to be worst hit, with short-dated gilts less badly affected because they are closer to their redemption date, when investors will receive a capital repayment.
■ Corporate bond funds
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These funds are made up of high- quality investment grade bonds, issued by companies with the best credit records. They carry a bit more risk than gilts so their yields are slightly higher to reflect that extra risk. However, they are likely to be almost as susceptible as gilts to interest rate rises, so investors might want to check how much of these funds they want to hold when rates are poised to move upwards, says Mr Lowcock.
■ High-yield bond funds
The bonds that make up these funds are at the higher end of the risk-reward spectrum. Their higher yields give them slightly more of a cushion against interest rate rises, but they are more sensitive to the possibility of a default by the company issuing the bond.
Ms Schooling Latter says: “You need to pick your high-yield bond fund very carefully, especially at a time when the sector is not looking particularly good value.”
■ Strategic bond funds
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The great advantage of these funds, says Mr Lowcock, is that they can range across the different bond sectors and have more tools in the bag than a more narrowly focused fund. He says: “They can use derivatives, they can identify pricing anomalies and they can make money in falling, as well as rising, bond markets. This means they are well suited to the uncertain conditions we are likely to experience over the next couple of years.
“However, you are unlikely to get as high a yield as you might with some other bond funds.”
Ms Schooling Latter adds: “It is vital that when investors look to restructure their bond fund portfolio they do so in a measured way. The biggest danger for all bond investors is that they panic and trigger a general scramble for the exit, which would produce the worst possible result.”