Last Thursday’s interest rate decision saw the Bank of England hike interest rates by 0.25 percentage points as expected. Afterwards, interest rate swap curves were suggesting that UK interest rates would peak at about 5.75% before falling back to the vicinity of 4% over the medium term. The UK yield curve, which plots the yields on government bonds of different maturities was still inverted – short-term rates higher than long-term rates – which is traditionally seen as a sign of an impending recession. The cost for government borrowing over 10 years was 4.4%.

In the US, where 10-year government borrowing cost is about 4.1%, the yield curve picture looks very similar. Commentators seem to think that the recent interest rate increase to a target range of 5.25%–5.5% may be just 0.25% off the peak. US inflation seems to be falling even while economic growth and indicators such as jobs data appear robust.

Conversations over recent weeks suggest that managers of equity-focused funds are relatively upbeat, on average expecting a ‘soft landing’ for the economy. However, bond fund managers tend to be more pessimistic.

Whether or not we get a recession makes quite a big difference to the returns of bond funds. This is already evident in the contrasting fortunes of funds in the AIC’s Debt – Loans and Bonds sector such as Henderson Diversified Income (HDIV ), Invesco Bond Income Plus (BIPS ) and CQS New City High Yield (NCYF ).

HDIV has the lowest underlying investment return over three years with net asset value (NAV) including dividends dropping 2.9% per annum on average. Setting aside the NB Distressed Debt funds in run-off, its shares trade on the widest discount, currently 12.3% below NAV.

Fund managers Jenna Barnard, John Pattullo and Nicholas Ware have positioned the portfolio to weather a recession. They say that several of the economic lead indicators they follow have been ‘flashing red’, which suggests that the US Federal Reserve may soon be cutting interest rates again.

A recessionary environment might be expected to lead to much higher defaults by borrowers. The managers’ style has an ingrained bias to quality in any case, but they have been reducing the trust’s exposure to riskier high-yield bonds in favour of safer investment-grade credit. They have also been focusing more on shorter-duration bonds less vulnerable to interest rate movements.

In an update published in June, they said that they did not believe the rush to take advantage of the higher yields now available from bonds was the right approach for the current market backdrop.

By contrast, Invesco published a global fixed income strategy report at the end of June which suggested that a US recession was unlikely in 2023. The report noted that US inflation expectations had come down – putting less upward pressure on wages, while firms were also hanging on to workers. However, Invesco still thinks that inflation will remain above target, so it is not expecting any big reductions in US rates.

BIPS fund manager Rhys Davies’s quarterly report to the end of June sounded a more cautious note. He expected to see more volatility over the rest of the year. Nevertheless, BIPS has far more higher yielding, non-investment-grade exposure than HDIV – more than 75% of the fund to HDIV’s 50%. That is what has been driving its outperformance with NAV including dividends up 1.5% a year on average over three years. That is probably why it trades at par or at asset value. Interestingly, both HDIV and BIPS trade on about the same yield of 7.1%.

NCYF’s yield is far higher, currently running at 9.8%. After a recent wobble in the rating, it has returned to a small premium over NAV and its three-year returns trounce the other two funds at an average of 8.5% per annum.

In his commentary for NCYF’s June factsheet, Ian (‘Franco’) Francis was concerned about the chance of a recession in the UK and the strength of core inflation, although he would have written this before the release of inflation figures which came in a bit better than expected for that month.

NCYF achieves relatively high yields by targeting niche and often unrated issues that would be discounted by mainstream fixed income investors. These bonds are often less liquid, but Francis aims to hold these through to maturity and backs debt issued by a relatively narrow range of core issuers that he and the CQS credit team know well.

Francis also has the freedom to buy equities, and this has often proved a valuable source of extra income. Interestingly, NCYF’s NAV returns have tended to be less volatile than many of its peers.

Last month, HDIV’s chairman acknowledged the trust had almost exhausted its revenue reserves in support of its dividend and suggested the company’s structure was hampering the managers’ ability to preserve capital in real terms. The board is wondering whether HDIV should pursue an alternative investment process.

I have no insight into the likely path that it will choose, but the direction of the economy will have considerable influence over sentiment towards the trust. If recession hits and interest rates are cut, HDIV’s performance could improve quite dramatically. Equally, if inflation does not ease as quickly as hoped and central banks decide to maintain high rates for longer, perhaps even increasing them again, the outlook will be less rosy.

James Carthew is head of research at QuotedData.

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