The coming sell-off in bonds is one of the worst-kept secrets in finance. The British government is paying investors just over 2% to lend it money for ten years or more. That's poor value for everyone except the Treasury.
With inflation above 2.7%, this implies you won't even break even in real terms (after inflation). Yet knowing bonds are poor value, especially if inflation starts rising in any recovery, is different from predicting when the upheaval will happen. Yields on longer-term government securities (gilts) could go even lower if bearish investors are right about Britain turning into the next deflationary Japan.
Yet it's hard to dispute the fact that highly-rated government bonds represent poor value over the long term. The key risk is rising inflation, especially if the global recovery picks up speed. Central bankers have been keen to target a higher inflation rate as a core part of their policies.
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If inflation starts rising, bonds could be in trouble, with longer-maturity government bonds especially vulnerable (ten-year rates could move from today's yield of around 2% to as much as 4% in months, if prices tumble during a bonds rout).
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So how should investors react if this happens? One option is to buy dividend-orientated equities, where the yield is higher than gilts and there's also the potential for the share price to rise. But not everyone will feel comfortable moving into risky assets if, for example, they are relying on fixed-income bonds for a stable income.
The safest solution may be to shift out of gilts with a long maturity into ultra-short-duration alternatives (up to one year) the chance of a capital loss will be relatively low, although the yield will also commensurately be very small.
But what if you need more income? If long-dated gilt yields do jump to 4%, for example, then funds that invest in top-class, investment-grade corporate bonds will also be hit badly. But as we move out along the spectrum of risk into higher-risk, sub-investment-grade (meaning riskier issuers) corporate bonds, the likelihood of a big capital loss decreases. A doubling in yields to 4% for low-risk gilts is likely to have a proportionately smaller impact on a corporate bond fund yielding 8% than on one yielding just 4%.
The price of higher-risk, sub-investment-grade corporate bonds is more influenced by the business cycle, economic recovery and profit margins. As the global economy slowly picks up, inflation will probably start to rise, but that could be good for corporate margins in the short term and corporate defaults should fall.
Lots of funds invest heavily in higher-risk corporate bonds (funds from M&G, Pimco and Royal London top most lists). But I'd prefer a manager running a small fund who is able to move money between all kinds of bonds and income securities and is willing to take an international approach.
Kevin Doran's Brown Shipley Sterling Bond fund (tel: 020-7606 9833) fits the bill. He's willing to take big bets on anything from building society bonds (PIBs) through to traditional corporate bonds issued by European utility giants.
In an economic environment that's benign for growth but dismal for gilts, I'd also look at funds that lend to American corporations, especially mid-sized firms. Greenwich Loan Income Fund (LSE: GLIF) and Carador (LSE: CIFU) are funds that use relatively complicated structures to invest in these American issuers, with yields in double figures. But be aware that this is a risky income option if investors fear a revival in credit defaults in 2014, both funds could be hit hard.
Index-linked bonds are a good alternative, especially those issued by companies. The best bet is the M&G UK Inflation-Linked Corporate Bond fund (0800-390390) run by Jim Leaviss. As inflation rises, these bonds should become even more popular and yields on the small number of issuers should start to rise.
Floating-rate bonds are another way to access this theme. With these, the yield rises as interest rates increase, a likely knock-on effect from higher inflation. US-based Neuberger Berman has a global fund called the NB Global Floating Rate Income Fund Limited (LSE: NBLS), which invests in these floaters' and yields just over 5.5%.
Another tactic is to invest in international bonds from relatively safe issuers where the yield is decent. The Asia-Pacific region (excluding Japan) is seen as an increasingly low-risk environment for bonds, given its solid fundamentals.
Many emerging-market government bonds from the likes of Singapore have soared. Yet EFG Stratton Street's Wealthy Nations Bond fund (020-7766 0816) is still buying bonds from countries it thinks offer good value with yields of 6% or more.
What would I do? If I had to own fixed-income securities, I'd diversify across risk levels and globally, with small investments in higher-risk bonds from GLIF and Carador, a bigger stake in the Brown Shipley fund plus significant exposure to the M&G and Wealthy Nations funds. I'd also want exposure to income-producing assets like PIBs issued by the big mutual building societies the small offshore Guardian Permanent Income fund (020-7001 2650) invests in securities from Nationwide and Coventry Building Society and yields over 6%.
Lastly, I'd look at a fund from hedge-fund leviathan Brevan Howard called Credit Catalysts (LSE: BHCG). This adventurous fund could be sitting pretty if there was a sudden bond sell-off, as it can go both long and short bonds and so is well placed to make money when volatility in bond markets shoots up. Just be aware that this fund doesn't pay an income.
