Buy bond funds ‘backed’ by the Bank of England, sell those close to the junk bond precipice

Investors who hold bond funds could see the value of their assets rise thanks to action taken by the Bank of England in response to the coronavirus epidemic.

Others, however, could suffer if their bond fund’s holdings are downgraded to “junk” status because of the damage caused to businesses by the pandemic.

Savers are urged to scrutinise their bond funds carefully to check whether they are in the former or latter category.

Earlier this month the Bank of England said it would start to buy investment-grade corporate bonds as part of its “quantitative easing” policy to support the economy. The presence of such a significant new buyer in the market is likely to boost the price of the investment-grade bonds it buys – and the funds that own those bonds will benefit.

Investment-grade bonds represent loans to creditworthy companies that are expected to be able to survive the crisis. They are the safest tier of corporate bonds.

At the other end of the scale are “junk” bonds, which are below investment grade and at much more risk of failing to keep up interest payments. 

Some bond funds have large holdings of bonds that are currently investment grade but just one notch above junk and therefore in danger of becoming junk bonds if the credit rating agencies downgrade them. Such downgrades are expected to become much more common as businesses everywhere suffer from the effects of lockdowns.

When a bond is downgraded to junk, many holders will sell it, so the price falls. If there is a wave of such downgrades, bond funds that own the affected bonds will suffer. Junk bonds are also not eliglible for the Bank of England’s bond buying programme. 

Lloyd Harris, who manages the £325m Merian Corporate Bond fund, said: “In our view, investment-grade corporate bonds are currently priced cheaply compared to recent history and, given the extraordinary central bank stimulus to come, we expect an appreciation in the value of these bonds.

“The Bank of England is smiling on investment-grade corporate bonds.” His fund has more than 80pc of its holdings in investment-grade bonds, most of which are rated A or higher – the safest category.

Mr Harris said investors should watch for “value traps” among corporate bonds rated BBB. These are only just investment-grade and are at risk of downgrades to junk.

Investors who want to check their bond fund’s holdings will find the information on the portfolio’s monthly factsheet, available through the website of the fund management firm  or the investor’s fund shop.

On the factsheet there should be a section that splits the fund’s holdings bonds by credit rating. AAA is the highest rating a company can achieve, followed by AA, A and then BBB – the final rating before a bond is no longer designated as investment grade.

The more bonds a fund owns in companies with an investment-grade credit rating, the more likely it is to benefit from the Bank’s bond purchasing programme.

One option is the Aberdeen Standard AAA Bond fund, which has more than 80pc of its portfolio in the highest-rated corporate bonds. Its yield is just 1.5pc, however. Another portfolio that has a high allocation to AAA bonds is the £365m Church House Investment Grade Fixed Interest fund. It has more than a third of its money in AAA bonds and yields 2.21pc.

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