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Mark Dampier: Royal London gives you extra

While corporate bonds remain vulnerable to an interest rate increase, the Royal London Sterling Extra Yield Bond fund is currently yielding in excess of 7 per cent.

I last reviewed the Royal London Sterling Extra Yield Bond fund in May this year. Given the continued news flow on bonds I thought it was worth a revisit.

It is no secret most commentators and analysts, including me, felt government bonds issued by the UK, US and German governments looked overpriced when 10-year yields fell to record low levels around 1.5 per cent.

This year yields have risen to around 3 per cent and prices have correspondingly fallen. This is partly because the US government suggested it would begin to slow its quantitative easing programme, which currently involves buying huge quantities of bonds.

Last week, markets were surprised when the US Federal Reserve decided to postpone this move and yields have since fallen again. That said, I think it is only a postponement and we could see bond purchases slow later this year which would be positive as it would indicate the economy is on a recovering trend.

Sovereign bonds tend to be bought mainly by institutional investors, such as pension funds and insurance companies, though. Most private investors focus on corporate bonds in their Isa or Sipp portfolios which are issued by companies and linked to their credit worthiness. However, their pricing still tends to be linked to government bonds, though within this there is a degree of what might be termed fair value.

Fund manager Eric Holt suggests the yield on 10-year UK government bonds, or gilts, might hit 3.25 per cent next year. Longer term he believes fair value might be 5 per cent, implying further price falls and weakening the case for buying them. Given the state of the economy today he believes yields are at about the right level.

Countries in Europe, including the UK, still have big budget deficits and he sees little risk of inflation getting out of control any time soon. Inflation risks tend to be centred on energy and food prices which central banks can’t really control.

With corporate bonds yielding around 1.5 per cent more than gilts he sees some value in this area of the market. He suggests the gap could fall back to around 1 per cent as many corporations have got their acts together in terms of their financial strength and this could see their bonds perform well.

The dilemma facing investors is that while government bond yields may creep up there seems little sign short-term interest rates are likely to rise soon.

In the UK the market is pricing in the first interest rate move before the next general election, but the market is usually wrong. Greater cynicism would suggest after the next general election would be the earliest potential date for a rise in interest rates.

This means investors negative on bonds either have to suffer short term cash rates of about 1.5 per cent gross; or rotate into the equity market. It might sound sensible, but if there was a rout in the bond market it would hit equity markets too. Indeed, the Federal Reserve’s announcement of a possible tapering of QE was enough to send equities falling much further than bonds.

The fund currently has 38 per cent exposure to high yield bonds. Holt recognises yields in this area of the market are close to record lows. However, he also notes many issuers of high yield bonds are actually high quality businesses with less bank debt (which ranks ahead of their bonds in order of repayment) than in the past. There has been a lot of bank to bond refinancing (swapping bank loans for bond issues) and he believes these companies are well placed to meet their obligation providing they can continue to refinance.

Holt concluded our meeting by saying the high yield market is not overvalued, but is more fair value. An attractive level of income remains on offer for investors with a long-term horizon. The fund currently offers a yield of 7.2 per cent according to Mr Holt and with 177 holdings is well diversified.

Many buy to let investors are happy to buy illiquid property with yields of only between 5 per cent and 6 per cent. No one seems to ask them the question that if interest rates rise dramatically in future will they still want to hold property?

With a yield of over 6 per cent there is some safety margin built in to this fund while it also looks more defensive than an equity portfolio.

While I remain wary of the impact a rise in interest rates could have on investment grade corporate bond funds, I still think there is room for a fund such as this in an investment portfolio.

Mark Dampier is head of research at Hargreaves Lansdown

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