Hello, and welcome to the Morningstar Series, Ask the Expert. I am Emma Wall and I am joined
today by Emma Morgan, Portfolio Manager for Morningstar.
Hi, Emma.
Hi.
So the Fed decided not to raise interest rates in its latest meeting, but that doesn't mean
it is going to be put off forever. It is when, not an if now for both the U.S. and indeed
the U.K. for interest rates to rise. I think from the investors' portfolio what they need
to be aware. Is there are risks associated with raising interest rates and – rising
interest rates. So what are those risks to investors' portfolios?
Yes, this is something that I think has been on everyone's minds for a number of years.
The last time the Fed actually raised rates was back in 2006. So it feels like we've been
talking about it in a long time. But as you said it looks like we are on the cusp of a
rate rise at some point in coming months.
So for investors I think they need to consider the interest rate sensitivity of their bond
portfolio, so the measure of that is duration. So if your overall portfolio has a duration
of about 10 years, that means that a 1% interest rate rise could lead to a potential loss of
about 10%. So for U.K. investors you need to look at the mix within your bond portfolio
and the government bonds typically have a duration, at the moment, of about 10 years
and corporate bonds have a duration of about 8 years and high yield bonds have a duration
of about 4 years. So, obviously, their interest rate risk is highest in government bonds and
lowest in high yield, although with high yield you are going to get a considerable amount
of credit risk and obviously less diversification benefits than you will with government bonds.
Of course, professional investors are doing this blend themselves, but private investors
are not picking and choosing individual bonds to buy that will be left to either a bond
fund manager or indeed if they've got a multi-asset fund, the bond element within that multi-asset
fund. So what actions can individual investors take to ensure that those people making those
asset allocation decisions on their behalf are taking the right decisions?
Yes, so what an investor can do is if you have a mix of government bonds and corporate
bonds, you could look to add a little bit more in high yields. As I said that has lower
duration, but you will be taking more credit risk and those bonds are likely to perform
more like equities than they are bonds, but within an interest rate environment they typically
do quite well, because even though yields are rising, you will get the benefit from
credit spread compression. So you could modestly rotate your portfolios from some government
bonds to investment grade bond and invest in a high yield fund.
One high yield fund that we like at the moment is the Kames High Yield Bond Fund. This is
managed by two very experienced managers Phil Milburn and Claire McGuckin. We really like
that team, their (colleagic) approach and their thoughtful approach towards the sector
which combines both rigorous credit analysis and also macroeconomic analysis.
And if you don't want to have separate bond funds for each of those allocations, you want
to just really outsource your bond allocation to the professionals, what about strategic
bond funds or absolute return bond funds because they are becoming increasingly popular, aren't
they?
These are very popular funds that we're seeing a lot of demand from investors. So a strategic
bond fund, you are basically outsourcing the asset allocation decision between government
bonds, potentially investment grade, potentially high yield. And this is a very diverse sector,
so we would caution that investors look at every bond individually – every bond fund
individually, understand what they are investing and what their aims is.
One fund we do like at the moment is the Henderson Strategic Bond Fund. This fund has typically
had more credit risks, so it will have a substantial weighting towards high yield bonds and also
has historically had quite a lot of financials. So, you will be taking quite a bit of credit
risk – but we really like the two managers there, that's managed by John Pattullo and
Jenna Barnard.
What about an absolute return bond fund?
Yes. So an absolute return bond fund is very different to a strategic bond fund, it's more
akin to cash, it's more likely to deliver you a cash plus type return. But if the investors
really want to reduce the credit risk, reduce the duration, but still be invested in bonds,
it might be an interesting option. I would say, in general, these funds typically have
had quite a short history and haven't proven themselves over different market environments.
But one fund we do like is the BSF Fixed Income Strategies Fund. So this fund is run by BlackRock
by a guy called Michael Krautzberger. We really like that team. We rated number of his long-only
funds and we think that his approach towards fixed income is well suited to an absolute
return. So he is very risk aware and typically builds diversified portfolios with a number
of offsetting positions.
Emma, thank you very much.
Thank you.
This is Emma Wall for Morningstar. Thank you for watching.