Time for something different?

Financial advisers and investors haven’t always made the investment company sector their first port of call when looking for bond funds. After all, the open-ended fund industry offers hundreds of fixed income options, providing a means to access everything from gilts to high-yield corporate debt. Today, however, might be the moment to cast the net more widely.

In particular, the Association of Investment Companies’ Loans & Bonds sector currently lists a dozen funds. They invest in a very wide range of debt instruments issued by corporate borrowers – conventional bonds, but also other types of security. Currently offering an average yield of around 7%, these funds are generous when it comes to paying income.

Conventional wisdom is that it does not make sense to invest in bonds during periods of rising interest rates, such as the current environment. As rates rise, investors naturally demand additional income from bonds; higher bond yields mean lower bond prices and capital losses, which is why bond investors fear tighter monetary policy.

Still, many investors don’t currently like the prospects for equities either – they’re thinking about the bond market as a safe haven amid the ongoing volatility of world stock markets. And the yields that bonds offer, for now at least, still look generous compared to what’s available from bank and building society accounts, so they appeal to income seekers too.

It's a conundrum. Bonds continue to offer sanctuary from equity risk and provide a dependable source of income – but investors are wary about the impact of rising interest rates on the capital value of bond funds.

Hence the need to take a more imaginative approach to this asset class – which is where investment companies come into their own. The broad range of securities in which Loan & Bond sector funds can invest means their managers have more freedom to address some of the challenges facing the market.

One example is the growing exposure of some funds to floating-rate bonds and loans. These are bonds where the rate of interest paid by the issuer is variable, rising and falling in line with monetary policy; this provides protection from the capital losses that fixed-income securities generate in a rising interest rate environment.

Another option for fund managers is to shift more of their portfolio into high-yield securities. These are much less sensitive to interest rate risk; rather the fund is managing credit risk – the possibility that the issuer might default on repayments.

Short duration bonds and loans also have a useful role to play here – the less time it takes for investors to receive the full value of the principal of the bond, the less exposed they will be to changes in interest rates. Private debt not traded on a public market is another possibility.

Finally, the breadth of exposure available is not the only reason to consider investment companies for debt market exposure in the current environment. The closed-ended structure of these funds is also an important consideration.

In an open-ended fund, managers must cope with the inflows and outflows of cash as investors put money into the fund or take it out. This can cause real difficulties with managing the portfolio, particularly during times of stress. Managers may be forced to sell assets at a time not of their choosing in order to meet redemptions; and they will be wary of less liquid holdings, such as private debt, which may not be easily cashed in quickly.

Closed-ended funds with a fixed pool of capital don’t suffer these problems. Investors can get in and out by buying and selling shares in the fund on the stock market, but the underlying portfolio is unaffected. That leaves the manager free to get on with the job – and to build a portfolio best suited to the prevailing market conditions without having to worry about liquidity and redemptions.