Chris Huelin, manager of the Collins Stewart Total Return Bond Fund, outlines how investors can take advantage of rising yields.

Bonds have played an essential part in portfolios over the past 30 years or more, acting as both an equity diversifier and providing a safe and stable flow with a significant down trend in yield. Periods of market turmoil have generally been accompanied with an accelerated drop in yields – the perfect equity diversifier. Our concerns, however, revolve around the likely future path of yields, as suggested by both history and fundamentals.
 
Bond yields below three per cent have been a rare occurrence, with just three sustained instances over the past 200 years or more, namely the late 1800’s, the Great Depression and the Second World War.

Furthermore, yields have a history of multi-year trends, so if we’ve seen the bottom of the last down trend, then it would seem likely that a multi-year up trend has now begun. That’s not to say that yields are likely to rise in a uniform manner from here, far from it.

Our momentum indicators show that the current rise in yields has been significant, and that bonds are close to short-term oversold levels while traders speculative positions are close to neutral indicating some short-term market indecision. That said, the longer-term fundamentals are clear – yields are likely to be in an uptrend from here.
 
The question now is what to hold as yields rise.
Short-dated, or low duration, bonds have a much lower capital value sensitivity to higher yields than longer-dated equivalent issues. That makes the short end of the yield curve a good place to start, particularly while short rates (or policy rates) remain at historically low levels.

Alternatively, floating rate notes are bonds that have coupons that are re-set (normally every three months) to a rate above the current three month LIBOR (London Interbank Offered Rate). These assets would normally trade around parity and hence provide a cash deposit style return. However, these short-dated (three years) securities have been caught by the same risk contagion that other bonds have suffered.

It is therefore possible to acquire these bonds at significant price discounts which lead to very attractive yields to redemption of circa five per cent. These returns would be enhanced by any increase in LIBOR rates over the life of the bonds whilst retaining a lot of the attractions that corporate bonds offer.
 
Given our concerns about inflation, index-linked bonds ensure that capital value is maintained in real inflation-adjusted terms over the life of the bond. The use of this asset class has become far more important since 2003 as central banks – primarily the Federal Reserve – have used interest rates as an insurance policy against slowing growth pressures, regardless of the inflationary conditions.

Investors are left with the option of a negative real return on cash deposits or mildly positive real returns on conventional fixed coupon bonds. At first glance, the latter appears to be the sensible option but investors should be wary of locking in to yields at this point. This is because their return is fixed and when yields start to rise, the value of their capital falls as the price of the bond falls. Again, this makes shorter-dated index linked bonds a strategic option.
 
Finally, corporate bonds require some explanation. A blend of industries and issuers is nearly always the best way to optimise the risk reward profile of corporate bond exposure, but those industries considered to be ‘safer’ and of a less cyclical nature have become quite expensive, as demand has driven prices way over par and yields have fallen significantly.

Our favoured corporate bonds are high quality,  A/A rated financial institutions. These financial names do not have explicit government guarantees, but there is a perceived implicit government guarantee on the sector due to the essential role that the financial system plays in the global economy.

Furthermore, we believe that the yields at double the equivalent government bonds, offer sufficient returns to compensate investors for the added perceived risks being undertaken. The use of these strategies has provided clear positive performance for our fixed income process this year.
 
In summary, in order to get a meaningful return without taking any undue credit risk, we are adding to our position in shorter-dated index linked bonds, floating rate notes and high quality, AA/A rated financial institutions. We have taken profits on some of our corporate bond exposure as some corporate spreads narrowed substantially as rationality returned to the market and investor sentiment toward risk appetite increased.