Bond Funds in Rapid Popularity Rise Among Investors

Inflation rates in the UK have been rising of late, steady at a five-year high of 3% over the past couple of months, with further increases expected over 2018. Normal investment logic says that as an investment class, bonds become less attractive during periods of higher inflation. The real value of their fixed-income returns drops and they tend to start changing hands at less than their face value, especially if new bonds are issued that take higher inflation rates into consideration by offering a higher coupon.

3% is not exactly run-away inflation but it is slightly higher than the ideal level of around 2% targeted by the Bank of England, whose Governor, Mark Carney, recently stated that he expected further increases over the coming period. Inflation picking up is largely being attributed to the drop in the value of the pound due to Brexit uncertainty and not, for now, something to be overly concerned about in terms of it potentially getting out of control.

Bonds have been popular over the last few years in the context of record low interest rates but with interest rates and inflation both creeping back up their popularity would be expected to be dropping. As such, a trend which has seen Brits investing online through UK stock brokers put £4.9 billion into fixed income funds in the third quarter, and £9 billion over the course of this year. Bond funds invest into a portfolio of different bonds and can also use bond-based derivatives.

However, experts at the big UK stock brokers are somewhat baffled by why exactly now they are experiencing such a surge in popularity. Laith Khalaf, an analyst at Hargreaves Lansdown, the UK’s biggest online stock broker is quoted in The Telegraph as commenting that the trend was “very strange”, particularly with the heaviest flow of cash into bond funds coming over the summer as impending interest rate increases were being firmed up.

One possible explanation is that those actively investing online and following the markets are expecting a stock market downturn and have increased allocation to bonds as a defensive move. The long bull run moving into bubble territory has been much discussed and investors approaching retirement will be concerned that it popping now won’t leave them with enough time to ride a major correction out. The yield on 10-year UK Government gilts was also increased to 1.3%-1.4% from 1%, which may have tempted more people into bonds, whose returns rise as their face value drops. A further factor may be an ageing British population preferring the security of bonds to the stock market, especially after several years of gains, a trend that many feel has to end sooner rather than later.

There are some concerns that with most of the past decade, from the financial crisis onwards, having been good for bonds, many bond fund managers lack experience in dealing with an environment of rising interest rates. Interest rates don’t have to rise much for it to start to become difficult to realise good returns from bonds, even if many strategic bond funds invest more in emerging markets and corporate bonds than UK government gilts or U.S. Treasury bonds, that have low returns.

Exactly why bond funds are attracting so much capital at the moment remains an unanswered question, despite the several theories put forward. However, the most likely is simply that investors are attempting to preserve capital by getting out of equities in anticipation of a major correction.