Investment companies and bonds

Are you worried about the price of bonds? If so, you’re not alone – a growing number of bond market followers have been warning that 2015 could be the year that prices come tumbling down. Nobel Prize for Economics winner Robert Shiller has even republished his famous book on investment bubbles, Irrational Exuberance, with a new chapter on the bond market.

None of which is to say that the bond market is about to crash – less pessimistic investors have a case to make too. But for financial advisers who are concerned, the question is how to respond – clients want exposure to fixed income securities as part of a diversified portfolio and the funds that most advisers use to provide that exposure are going to find it difficult to get out of the way of a bond market collapse.

Open-ended fixed-income funds have been extremely popular with advisers in recent years and now have billions of pounds worth of assets under management. But the managers of such funds have only two options if they anticipate a bond market correction: moving the fund into cash or taking on derivatives positions that stand to benefit if prices fall.

Even these options are theoretical. In practice, the investment mandate under which many bond fund managers operate does not give them the freedom to make such aggressive moves – they may be prevented from holding more than a certain proportion of the fund in cash, or banned altogether from shorting the bond market.

The problem is not that the debt market does not offer securities that might be profitable holdings in the event of a correction. In particular, loans that carry a variable rate of interest – as opposed to the fixed income paid by bonds – could be attractive. These bonds will become more attractive as interest rates rise (or expectations of a rise increase).

Unfortunately, however, unlike conventional bonds, these ‘floating-rate notes’ are not listed securities – and under European Union investment regulation, this limits open-ended funds to holding a maximum of 10 per cent of their portfolios in such assets. In other words, an asset class that might be particularly useful to bond funds in the current climate is largely out of reach.

Enter the investment company sector, which is not bound by the same restrictions on unlisted securities as its open-ended counterpart. Closed-end funds can – and do – take big exposures to floating-rate notes where they believe doing so is the right investment strategy. Indeed, there are several specialist funds that offer targeted exposure to floating-rate notes, as well as a number of more generalist debt vehicles with the option of investing.

This is one of those examples of where the greater freedoms available to investment company managers can really work to advisers’ advantage, enabling them to offer clients exposure to a much broader range of strategies to suit the prevailing market conditions. None of which is to say that the bond market is definitely poised to take a turn for the worse – just that if this is something you’re worried about, certain closed-end funds offer much more subtle options for planning ahead than is possible with an open-ended vehicle.