Isa ideas – government bond funds – too expensive or still a safe bet?

25th March 2014

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Investment journalist Cherry Reynard looks at the government bond sector and asks has their time passed or is there still a case for investing?

Government bonds are loans issued by governments to fund spending. Investors receive interest from those loans and the level of interest will depend on the perceived riskiness of the country. For example, at the height of the credit crisis, the Greek government had to pay over 10% higher than the German government to encourage investors to lend it money, because it was thought to be at high risk of default. Bonds will also have different times to maturity: a ‘short duration’ bond might mature in as little as a year, while long duration bonds may not have to repay investors for 20+ years. In general, governments have to pay a higher income to encourage investors to tie their money up for longer periods of time.

Fixed income is nearing the end of a 10 year bull run fuelled by lower interest rates. As the economic environment improves and interest rate rises become more likely, potential government bond investors have a dilemma. ‘Safe’ developed market government bonds now look very expensive, pay little yield and may sell off as quantitative easing is withdrawn and interest rates rise. Yet there are still sufficient risks in the world – the Ukraine, the Eurozone, emerging markets – to suggest that developed market government bonds still have a place as a portfolio ballast, offering some capital protection if stock markets fall.

Range of fund strategies within sector?

Developed market government bond funds are found in two sectors: UK-focused funds are found in the UK gilt sector, while international bond funds are found in the global sector. The UK gilt sector is relatively homogenous. Funds can vary the type of bonds they include in a portfolio and whether they are long or short duration, but in general, they have relatively little flexibility to add value over and above the gilt market. Nevertheless, active management can make a difference over the long term and 24% separates the top and bottom performing fund over five years. Performance will usually be dependent on whether the fund has the right duration bias for a particular market – if the market has favoured long duration bonds, for example, as it might do when interest rates look like they will remain low, funds with a portfolio of longer bonds will do well.

Managers of government bond funds within the global sector have more tools at their disposal. Different countries will be at different stages in their economic cycle – while some may be expanding, and raising rates to cool economic growth, others may be moving into recession and dropping rates aggressively. All of this will have a bearing on their government bonds. Global bond managers can therefore allocate between different countries, as well as using bonds with different maturity dates. Some may even have holdings in emerging market bonds.

Recent performance?

Over the past five years, the average fund in the UK gilt sector has grown by 19.4% (to 18th March). This compares to average growth from the UK Sterling Corporate bond sector of 59.3%, and from the UK Sterling High yield sector of 109.6%. By far the best performing funds over the past one, three and five years have been those with a bias to longer maturity bonds with the Newton Long Gilt, AXA Sterling Long Gilt and Henderson Long Dated Gilt the top three funds over five years.

In the global sector the picture is more mixed, with country selection also influencing performance. Those holding exposure to emerging market bonds have struggled as the sector has sold off. The aggregate performance of the global bond sector includes many corporate high yield bond funds and therefore is not helpful for those looking for pure international government bond exposure. Investors need to sift through the sector to find the funds with government-only exposure.

When does it perform well/badly?

UK gilts have tended to perform well at times when markets are worried – about the situation in the Ukraine, about the Eurozone debt crisis – and perform poorly when investors are more optimistic about economic growth. International bonds have the same risk/return profile, but different countries may be at a different stage in their economic cycle and therefore a global portfolio may not perform in line with a fund focused on UK government bonds.

What sort of investor does it suit?

Historically, government bonds have been a natural choice for income seekers. Investors could buy a long-term income stream and know their capital would be relatively safe. This is not necessarily the case today. The income is lower and capital values are at risk if interest rates rise. Nevertheless, they are still an important diversifier in a portfolio. Developed market government bonds will tend to rise when equity markets fall as investors place a premium on safety. Equally, some government bonds still offer a reasonable income, ahead of inflation. In general, those investors that have a longer time horizon and can therefore afford to take more risk should have lower weightings in government bonds.

Popular funds

Top 10 by performance (5 year) – UK Gilt sector

Newton Long Gilt Exempt – 36.5

AXA Sterling Long Gilt – 27.9

Henderson Inst Long Dated Gilt – 24.4

Threadneedle UK Fixed Interest – 20.1

BlackRock CIF UK Gilts All Stocks Tracker – 19.2

Allianz Gilt Yield – 18.9

Scot Wid UK Fixed Interest Tracker – 18.3

Invesco Gilt A Quarterly Distribution – 18.1

L&G All Stocks Gilt Index – 18.1

Scot Wid HIFML UK Gilt – 17.6

Questions investors should ask themselves

How important is a high income?

Do I want to stick to the UK or look internationally?

How important is capital preservation?

Has the manager added value over and above the performance of UK/global government bonds?

Investment experts comments and some suggested funds

Gavin Haynes, investment director, Whitechurch Securities

Funds in the UK Gilt sector can provide access to a well diversified portfolio of gilts with differing maturities that can be managed according to which are more desirable in the prevailing climate. Management fees need to be looked at closely in a gilt fund because of the relatively low risk profile, return expectations are going to be low so high charges can have a marked effect upon the net returns.

In the low interest rate environment gilts have rallied strongly over the past five years. Interest rates are the key determinant upon the attractiveness of gilts. Increasing interest rates will have a negative effect in making their coupons less attractive relative to cash based investments. For our fixed interest exposure, we continue to focus on corporate debt as we see more value in credit spreads over government bond yields. However, at some stage I have no doubt that we will include gilts in our portfolios once again.

Suggested funds

M&G Gilt and Fixed Interest fund

Gary Potter, joint head of multi-manager at F&C Investments

“We don’t currently have any developed market government bond exposure. I don’t think that the bond market is going to collapse – there are still concerns about the world and interest rates rises are still some way off – but I think the risk/reward for mainstream government bonds is still poor.”

Funds:

F&C Global Macro

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