Fund selector: Picking the right bonds

It seems clear that the inevitable rise in bond yields has begun and that interest rate rises will eventually follow once quantitative easing (QE) has been fully stopped.

Federal Reserve chairman Ben Bernanke has clearly signalled that the tapering of QE will begin when conditions, especially with regards to US unemployment, are appropriate. The sovereign bond market has overreacted somewhat with 10-year yields rising above 2.5 per cent.

This prompts investors to consider what type of bonds should be held in a rising rate environment, particularly for portfolios where fixed income assets are required as part of their overall asset allocation.

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One approach is to seek out bonds where the sensitivity to duration is limited. The ‘shopping list’ is relatively short as both government bonds and investment-grade corporate bonds have significant duration. Additionally, corporate bond spreads may not necessarily compress as rates rise – it depends on whether companies are thriving or defaults are rising.

High yield bonds may offer some protection as their sensitivity to equities is typically greater than their sensitivity to duration. Again though, the case is not clear cut as it depends on what the economic impact of rising rates is. If it chokes off growth then high yield bonds will suffer in a similar way to investment grade bonds. Regardless, none of the aforementioned asset classes are cheap.

An opportunity does exist in the floating rate, as opposed to the fixed rate, segment of the bond universe. Specifically asset-backed securities (ABS), including mortgage backed securities (MBS) and loans, are attractive in such as environment.

Both instruments have the very important characteristic of yielding a coupon based upon the London interbank offer rate (Libor).

In other words, they pay a fixed spread above this rate, for example Libor plus 4 per cent, so that yields rise as Libor rises and as such they have negligible duration or interest rate sensitivity.

They are very different assets to each other, however. ABS comprise bonds that are based on packages of MBS, credit card debt or car loan debt. They are tiered by quality and each tier is usually rated by the ratings agencies such as Moody’s or Fitch.

Loans are debt issued directly to individual companies – typically highly indebted ones with private equity ownership. Again, they are commonly rated by rating agencies – the majority being sub-investment grade – and growth here has been rapid as banks have been retrenching from lending directly to such companies, partly for regulatory reasons.

While these two asset classes do not suffer duration risk, they are not without risk – the primary one being default. Specifically borrowers can fail to make repayments on the loans issued to them and this is more likely as interest rates rise. These instruments can have a range of credit ratings and are relatively niche areas.

Investors therefore need to choose a fund or manager with appropriate skills and experience in assessing the creditworthiness of the loans and the most attractive tranches of ABS. An information advantage can be gained in both asset classes through, in the case of ABS, careful analysis of the underlying home or card loans and, in the case of European loans, being classified as ‘private’.