How to choose between corporate and government bond funds

Central banks might be making cuts, but interest rates are still higher than they were in the previous decade, which gives bond funds the chance to deliver decent returns. These funds offer investors diversification and lower volatility – particularly helpful for those with short investment horizons or a lower risk appetite.

But deciding which bonds to buy and how to go about it is not easy. As a starting point, investors can opt for government bonds, corporate bonds or a mix of the two; these asset classes have performed quite differently and, to an extent, are exposed to contrasting economic factors.

Tight spreads

As a basic rule of thumb, corporate bonds offer higher returns than government bonds, because they are riskier – on the basis that a private company is more likely to default on its debt than a developed country government.

The gap has been striking over the past three years. As the chart below shows, both sterling corporate debt and gilts (as UK government bonds are commonly termed) dropped in value (and yields rose) in 2022, as inflation went up and rate hikes began. But while corporate bonds have since staged a valiant recovery, gilts are still decidedly struggling.

Credit spreads, which represent the difference in yield between corporate and government bonds of the same maturity, are now especially tight compared with history. Given that the yield and value of a bond are inversely related, this suggests government bonds are cheap, corporate bonds are expensive, or a combination of the two.

Oli Faizallah, head of fixed income research at Charles Stanley, thinks the first of these options is true. “Corporate bonds are expensive relative to history, but the ‘all-in yield’ is keeping them attractive,” he says. “With perceived default risk to be low and fundamentals remaining strong, this ‘all-in-yield’ has sustained [demand for corporate bonds].”

Government bond yields paint a more nuanced picture, he argues, which also depends on the country you look at. “In the UK, inflation remains elevated, and the Bank of England has maintained a tighter policy stance. This has led to high real yields and a steep term premium,” he explains. “As such, yields appear reasonably priced, and reflect the UK’s fiscal challenges and structural market shifts, including reduced demand from pension funds and increased issuance.”

The concept of the ‘term premium’ refers to the fact that investors demand higher payouts to hold bonds of longer duration, to balance their higher sensitivity to interest rate changes. This is because the price of a longer-duration bond has further to fall if interest rates rise (and vice versa: they return more if interest rates are cut).

Experts have different opinions on what all of this means and how investors should approach the bond market at this juncture.

“You buy gilts for certainty – you know if you hold until maturity what your return will be,” says Ben Yearsley, investment director at Fairview Investing. “That’s fine, but I would still take the additional profit on offer from corporate bonds. Many [fund] managers I speak to are focusing on the shorter-dated corporate bonds – that seems sensible as it lessens the impact of rate changes on prices and it also leaves you less exposed to defaults.”

Faizallah likes a strategy that combines short-dated corporate bonds and longer-duration (up to 10 years) government bonds. “This allows us to manage credit and duration risk independently,” he explains. Unlike government bonds, corporate debt is not offering much of a term premium at the moment, so investors are not being compensated for taking extra risk there, he argues.

Jason Hollands, managing director at Bestinvest, has a more risk-averse stance – he prefers short duration across both government and corporate bonds, and “strongly favours” government debt overall.

What to buy

You have a range of options to build exposure, depending on what you want to achieve. You can leave the decision-making to the professionals and opt for a strategic bond fund. This is a good option for many because it saves you from having to figure out the intricacies of the bond market. However, you still want to check what your strategic bond fund invests in and what it is trying to achieve; because they offer such a flexible approach, they can be pretty different from one another.

The top-performing funds in the Investment Association’s sterling strategic bond sector tend to be skewed towards corporate bonds, high-yield debt and other credit sectors. Examples include Aegon Strategic Bond (GB00B3ZLQW29), Artemis High Income (GB00BJMD6R83) and Royal London Sterling Extra Yield Bond (IE00BD0NCD64), whose allocations to government bonds as at 30 September were just 11.6 per cent, 9.5 per cent and 1.6 per cent, respectively. The Artemis fund even has 17 per cent invested in stocks.

The Investors’ Chronicle Top 50 Funds list favours TwentyFour Dynamic Bond (GB00B5VRV677), which has 19 per cent in government debt. The fund targets a combination of growth and income and has exposure to a broad range of bond types.

One strategic bond fund with a higher exposure to government bonds, which has still performed decently over the past three years, is M&G Optimal Income (GB00B1H05718); it had 58.4 per cent in government bonds as at 30 September. In its latest monthly commentary, the managers said they were also “inclined to gradually reduce” their corporate debt positions.

Alternatively, you can build a bond portfolio in a more granular manner, deciding on the proportion of government and corporate bonds yourself – even making some calls on duration.

If you just want some safe gilts to hold to maturity, you can buy them directly. If you have exhausted your Isa and pension allocations, direct gilts are a useful asset for a general investment account because capital growth returns are free of capital gains tax. You can also use a gilt exchange traded fund – such as Amundi Core UK Government Bond ETF (GILS) or iShares UK Gilts 0-5 Years ETF (IGLS) for short duration exposure – although this will not benefit from the same tax advantages if held outside a tax wrapper.

If you want to hold multiple corporate bonds, a fund is the best choice, and it may be better to opt for an active option, rather than just indiscriminately buying the market. Faizallah currently favours active funds because of tight spreads across sectors and companies – “managers can cherry-pick more robust issuers that may be less likely to default in an economic slowdown”, he notes.

Active corporate debt fund options include Rathbone Ethical Bond (GB00B7FQJT36) and Artemis Corporate Bond (GB00BFZ91W59). If you want to focus on short-duration corporate bonds, Hollands suggests Royal London Short Duration Credit (GB00BJ4KW792).