Fund Spotlight: defensive bonds yielding more than 5%

After 14 interest rate hikes in the past three years and UK rates reaching a 15-year high, June has been signalled as a potential turning point for the tightening cycle.

With the Bank of England (BoE) set to make its next decision on 20 June, everyone is waiting to see whether the markets have been too eager in pricing in the inevitable rate cuts.

The macroeconomic environment plays a crucial role in bond markets and investment decision-making. Since 2022, rising interest rates have led to increased corporate and government bond yields, putting downward pressure on bond prices.

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Currently, the S&P UK Investment Grade Bond index has a yield-to-maturity of 5.73%, while gilts offer between 4.1% and 4,7%, depending on the maturity date. As such, the materialisation of compelling yields across higher-quality issuances has made the bond market an attractive investment again.

However, an uncertain economic outlook and the potential for disruption in the downward trend of disinflation, means that the exact timing of rate cuts is very hard for investors to predict. Even when central banks held rates steady throughout most of 2023, bond prices rose and fell as investors speculated on the timing of US Federal Reserve and BoE cuts.  

At such a turning point in the macroeconomic cycle, active managers must effectively manage the duration of a portfolio, which is a measure of how sensitive it is to interest rates linked to the years to maturity and the coupon of a bond.

Shorter-duration bonds are typically less sensitive to changes in interest rates and can protect capital values if rates rise, or expectations of rate trajectories change. On the other hand, higher duration bond prices will take more upside from falling rates and can present opportunities to lock in still-attractive yields for longer periods.

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Rathbone Ethical Bond I Acc, one of the oldest ethical bond funds in the UK, was launched in 2004. The fund aims to deliver a greater total return than the Investment Association (IA) Sterling Corporate Bond sector over any rolling five-year period. The team puts significant emphasis on: identifying and understanding investment themes across the macro, sectors, issuance and regulation to exploit or avoid various outcomes.

The fund has been led by long-standing manager Bryn Jones since its launch, joined by Stuart Chilvers as fund manager last year and Christie Goncalves as assistant portfolio manager this year. The fund has an impressive track record of managing duration well, aiming to navigate uncertain economic times by adopting a short-duration and defensive investment approach to limit downside risk during economic downturns.

From a sustainability perspective the team seeks investment opportunities that can mitigate negative environmental or social impacts, or present ethically aligned bond issuances. Greenbank Investments, the ethical, sustainable and impact research division at Rathbones, further supports the team’s ethical approach by providing an independent assessment of stock selection and engagement, having the final say on divestment.

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The fund applies extensive negative screening, excluding issuers engaged in alcohol, carbon-intensive industries, human rights abuses, poor employment practices, nuclear, pornography, armaments, gambling and tobacco. Issuers are then screened against environmental, social and governance (ESG) criteria and must fulfil at least one of the following: strong employment practices, sustainable environmental practices, community engagement or commitment to human rights, with a strong focus on governance.

After screening is applied, credit analysis is conducted using the four “Cs” – character, capacity, collateral and covenants. Bonds are selected on the basis of attractive valuations, credit rating and the issuance’s position in the company’s capital structure after screening.

What does the fund invest in?

Rathbone Ethical Bond invests at least 80% in sterling investment grade (AAA to BBB-) bonds, implying a lower risk of default, and up to 10% in non-rated bonds. The fund has a 4.8% allocation to UK government bonds, but it will only invest in green gilts, which are bonds reserved to finance the transition to a green economy.

Positioning wise, the fund is generally benchmark agnostic but compares itself from a performance point of view against the IA Sterling Corporate Bond sector. The fund is not constrained in terms of the number of holdings, currently holding 207 bonds from companies, charities, the UK government and international organisations, known as supranationals.

Over the past few years, the portfolio has become relatively concentrated in the financial sector. The managers like this sector because banks and insurers issued bonds to shore up their capital positions in the wake of the financial crisis in 2008, with many offering sizeable coupons. Because some of these bonds are being bought back by their issuers due to regulatory changes, the fund managers say the issuers can sweeten the deal by offering to buy them at premium prices.

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The duration of the fund is 5.7 years, which is less than peers and a comparable bond index. This reflects the raft of opportunities found across high quality short-dated corporate bonds, where yields are now strong enough to provide good protection against any downward movement in prices of the bonds.

However, in anticipation of the first round of rate cuts in the UK, the team have been adding duration in other parts of the portfolio, particularly to the long-dated green gilt allocation.

How has the fund performed?

Rathbone Ethical Bond fund has consistently outperformed the Markit iBoxx GBP Non Gilt benchmark and peers on both an absolute and risk-adjusted basis. Notably, in 2022, when bond prices were routed by the initial raising of interest rates by central banks, the fund provided some relative outperformance and drew down less than its peers and benchmark. It was helped by its defensive allocation in favour of shorter duration bonds.

A bond market rally in the final two months of 2023, when the fund returned 7.5%, was driven by expectations of sharp falls in inflation and resulted in strong one-year returns of 9.9%, beating the benchmark and peers by +2.4% and +1.7%, respectively. 

The fund has a distribution yield of 5.1%, higher than its average peer’s 3.6% in the Morningstar GBP Corporate Bond sector. The yield-to-maturity of the portfolio’s bonds is 6.24%.

Source: Morningstar Total Return (GBP) to 31/05/2024. Past performance is not a guide to future performance.

Why do we recommend this fund?

The Rathbone Ethical Bond fund benefits from experienced active managers, with Bryn Jones’ leading the fund for nearly two decades. The defensive investment process has also proven effective during times of economic uncertainty.

The top-down macroeconomic decision-making is complemented with thorough bottom-up issuer analysis, which results in robust investment decision-making. Furthermore, the collaboration with Greenbank Investments enhances the fund’s strength and resources, ensuring that selected issuances meet high ESG standards.

Despite a higher-than-average ongoing annual charge of 0.66% (versus peers’ 0.44%) the fund’s ability to provide a higher-than-average yield and consistent outperformance means it is a constituent on ii’s ACE 40 as an adventurous sterling bond investment option.

The latest factsheet can be found here.