Some of the largest bond funds in the UK are resisting the temptation to rush into shorter-duration paper, despite a likely increase in interest rates next year. As rates rise investors conventionally look for bonds with four years or less until maturity as the longer the duration of a bond the greater its price is likely to fall for the same increase in rates.

But rather than worry about the interest rate risk, professional money managers appear focused on adding high-yielding junk paper to their balanced-portfolios to boost income in a market characterised by low returns. Managers of Fidelity’s £1.4 billion Strategic Bond Fund are not joining the rush into shorter-dated paper. Curtis Evans, Fidelity’s investment director for fixed-income, does not believe that a northward movement in base rates would necessarily be bad news for bondholders. He points out that during the last cycle, where base rates leaped to 5.75% from 3.5%, fixed income returns were positive.

For Evans, the expected rise highlighted in Bank of England governor Mark Carney’s forward guidance (11 Mar), will be at a much slower pace than previous cycles, which should ease the impact of such a move on bondholders.

High interest

Investment manager BlackRock (BLK:NYSE) is also not rushing into short-dated paper either. Ben Edwards, a director in the US firm’s UK bond team, says it’s difficult to find value in short-dated paper that beats the yield on 10-year Gilts, which stands at 2.6%. He understands why people turn to short-dated paper with interest rates on the verge of rising to a reported 3% by 2017, but finds it difficult to put his clients’ cash to work on something that may yield only 2%. ‘I just think if that is the best we can do we should give them their money back,’ he says.

Edwards admits that he doesn’t want to get involved in a grab for low-quality assets, but that it is becoming harder to find value in the generic market. He has some junk in his UK bond fund, which he describes as being around the edges of sub-investment grade, and last year started looking to the US markets, where he bought paper issued by cable and tobacco companies, which yield around 5.5%. This is not a short-term strategy to ease the effects of low Gilt yields, but also makes sense in the search for income over a longer horizon.

With inflation continuing to fall and with growth slow relative to previous cycles, the yields on quality UK corporate bonds look set to stay low during the medium term as concerns over the levels of debt built up in the economy are set to hamper growth hence Edwards' US exposure. But Fidelity’s Evans believes there is value in UK corporate bonds and expects the market to yield low single-digit returns in the next 12 months.

Careful exposure

Fidelity’s Strategic Bond Fund is heavily invested at the lower end of investment grade bonds (BBB) issued by growth-hungry companies in the communications and non-cyclical consumer products sectors, such as food and tobacco. To boost the fund’s income some 35% of its assets are in high-yielding or junk bonds, which is balanced by 15% in safe government and inflation-linked paper. Indeed, the fund is up 3.3% in the year to date on a discrete performance basis, almost three times better than the 1.3% gain it made during the whole of 2013.