Mark Dampier: Bonds can still be worth buying despite the Fed's shock move on tapering

I last reviewed the Royal London Sterling Extra Yield Bond Fund in May this year. Given the continued news flow on bonds I thought it was worth a revisit. It is no secret that most commentators and analysts, including me, felt that bonds issued by the UK, US and German governments looked overpriced when ten-year yields fell to record low levels of around 1.5 per cent.

This year yields have risen to around 3 per cent and prices have correspondingly fallen. This is partly because the US government suggested it would begin to slow its quantitative easing programme, which currently involves buying huge quantities of bonds. Last week markets were surprised when the Federal Reserve decided to postpone this "tapering", and yields have since fallen again. That said, I think it is only a postponement and we could see bond purchases slow later this year.

Sovereign bonds tend to be bought mainly by institutional investors such as pension funds and insurance companies. Most private investors focus in their Isa or Sipp portfolios on corporate bonds which are issued by companies and linked to their creditworthiness. However, their pricing still tends to be linked to government bonds, although within this there is a degree of what might be termed fair value.

Royal London's Eric Holt suggests the yield on ten-year UK government bonds, or gilts, might hit 3.25 per cent next year. Longer term he believes fair value might be 5 per cent, implying further price falls and weakening the case for buying them. He believes yields are at about the right level. Countries in Europe, including the UK, still have big budget deficits and he sees little risk of inflation getting out of control soon. Inflation risks tend to be centred on energy and food prices which central banks can't really control.

With corporate bonds yielding about 1.5 per cent more than gilts, he sees some value in this area of the market. He suggests the gap could fall back to around 1 per cent as many corporations have got their acts together in terms of their financial strength.

The dilemma facing investors is that while government bond yields may creep up there seems little sign that short-term interest rates are likely to rise soon. In the UK the market is pricing in the first interest rate move before the next general election, but the market is usually wrong. Greater cynicism would suggest after the next general election would be the earliest potential date for a rise. This means investors negative on bonds either have to suffer short-term cash rates of about 1.5 per cent gross or rotate into the equity market. It might sound sensible, but if there was a rout in the bond market it would hit equity markets too. Indeed, the Federal Reserve's announcement of a possible tapering of QE was enough to send equities falling much further than bonds.

The Royal London Sterling Extra Yield Bond Fund currently has 38 per cent exposure to high-yield bonds. Mr Holt recognises that yields in this area of the market are close to record lows. However, he also notes that many issuers of high-yield bonds are actually high-quality businesses with less bank debt (which ranks ahead of their bonds in order of repayment) than in the past. There has been a lot of bank-to-bond refinancing (swapping bank loans for bond issues) and he believes these companies are well-placed to meet their obligations.

Mr Holt says the high-yield market is not overvalued, but is more fair value. An attractive level of income remains on offer for investors with a long-term horizon. The fund currently offers a yield of 7.2 per cent, according to Mr Holt, well diversified with 177 holdings.

Many buy-to-let investors are happy to buy illiquid property with yields of only 5 to 6 per cent. No one asks them whether, if interest rates rise in future, will they still want to hold property?

With a yield of above 6 per cent there is some safety margin built in to this fund, while it also looks more defensive than an equity portfolio. I remain wary of the impact a rise in interest rates could have on investment-grade corporate bond funds, but still think there is room for a fund such as this in an investment portfolio.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit hl.co.uk/independent