Portfolio Balancing: High-Yield Bonds, Cash and Inflation

 With financial independence now roughly 15 years away, I have started shifting my portfolio towards a 60/40 allocation: 60% in equity index funds and 40% in bond index funds.

Cash vs high-yield bond funds. There is currently an interesting alternative to bond funds in the UK: fixed-term savings accounts with guaranteed interest rates approaching 5%. There are products sometimes referred to as “treasury deposits”, with no account charges or management fees.

I therefore decided to compare four bond funds in which I have invested with fixed-term savings accounts. One important consideration is that both investments can be hedged into different currencies.

 I selected following bond index funds:

 CG (Carne Global) Aegon High Yield Bond Fund. This fund’s policy is to invest at least 80% of the Fund in a portfolio of high yield corporate bonds issued anywhere in the world and denominated in any currency.

It specifically targets higher risk bond by targeting companies whose credit rating is defined as Ba1 or below by Moody's or BB+ or below by Standard and Poor's or BB+ or below by Fitch or their respective successors or equivalents. High yield bonds also include non rated instruments. Where multiple ratings exist, the average credit rating is used.  

 I have also learned about convertible bonds. In the fund above can invest up to 20% into them. Official ongoing charges are 0.62%.

 Schroder High Yield Opportunities Fund. This fund pursues growth of between 4.5% and 6.5% per annum (after fees have been deducted) over a 3 to 5 year period by investing in bonds worldwide.  

 The fund focuses on below investment grade securities  (as measured by Standard & Poor's or unrated) at least 80%  of the capital.  The fund invests at least 50% of its assets in Pan-European fixed and floating rate securities.

Can invest up to 15% into convertible bonds.   Official ongoing charges are 0.72%.

 VanEck Global Fallen Angels High Yield Bond. This fund has an interesting concept. It invests in bonds that were considered investment grade when originally issued but subsequently fell below investment grade — so-called “fallen angels”.  The fund invests in corporate and quasi-government fixed-rate debt instruments publicly issued and listed on major US or eurobond markets by both US and non-US issuers.

 The investment thesis is that these bonds can become oversold because institutional investors may be forced to sell securities after they are downgraded from investment grade. Fallen angels can therefore sometimes offer attractive valuations while retaining, on average, higher credit quality than the broader high-yield market.

The fund uses a passive index-tracking investment approach, attempting to replicate the performance of the ICE Global Fallen Angel High Yield 10% Constrained Index.   The official ongoing charge is 0.40%.

 Vaneck Ucits Etfs Us Fallen Angel High Yield bond - objective is to replicate the price and the performance, before fees and expenses, of the ICE US Fallen Angel High Yield 10% Constrained Index. Focus on US bonds.

  

Fund	Management	Declared Fees*	Actual fees**	Current effective bond duration, yrs	Current Yield	Ex-fees Yield
CG Aegon	Active	0.62%	1% (0.62 + 0.34)	2.8	7.4%	6.4%
Schroder Opportunities	Active	0.72%	1 % (0.72 + 0.28)	2.7	6.7%	5.7%
VanEck Global Fallen Angels	Passive	0.4%	0.5% (0.4%+0.11)	4.6-4.7	6.5%	6%
VanEck Global Fallen Angels US	Passive	0.35%	0.35%	4.6	6.5%	6.1%

* From key investor information

** Ongoing charge + transaction cost

 Investment fees matter over 10 years.  The difference in fees is not trivial when investing for 10 years.

 If two otherwise similar investments differ by 0.30 percentage points in annual costs, that difference compounds to roughly 3% of the original capital over ten years, before considering any differences in investment performance.

 This is one reason I pay close attention to the difference between the headline management fee and the actual cost of holding a fund.   A passive fund with a lower fee does not automatically produce a better result, of course. The underlying portfolio, credit risk, duration and investment strategy also matter. But when two investments provide broadly similar exposure, fees become increasingly important over longer periods.

 Bond duration and inflation.   The different durations create an interesting dynamic when inflation and interest rates change.   Duration is a measure of how sensitive a bond portfolio is to changes in interest rates. Generally, the longer the duration, the larger the price movement when interest rates change.

 For example, if interest rates were to rise by another 2 percentage points, a simplified duration calculation would suggest approximately:

Aegon: 2.8 × 2% = 5.6% potential price decline

VanEck Global Fallen Angels: 4.6 × 2% = 9.2% potential price decline

 This is only an approximation. Actual performance would also depend on credit spreads, defaults, changes in the yield curve, income received and other factors.  Nevertheless, the shorter duration of the Aegon and Schroder funds gives them considerably more resilience against a renewed interest-rate shock.

The opposite applies if inflation and interest rates fall. The longer-duration VanEck funds could then benefit more from falling yields, with their bond prices potentially rising more strongly.  This creates an interesting trade-off: shorter-duration high-yield funds provide more protection against a renewed rate shock, while longer-duration funds have greater potential sensitivity to falling rates.

 Can high-yield bonds protect against inflation?

 This is particularly important for my financial independence strategy.

 If inflation remains around 4–5%, I should still be able to achieve approximately 1% annual growth above inflation based on the current yield assumptions.

 For example, if my current investment of $121,000 achieves a 1% annual real return for ten years, it would grow to approximately $134,000 in today's money.  At a 2% annual real return, it would grow to approximately $148,000 in today's money.   

 The current 12-month fixed-term deposit rate I am considering is approximately 4.6%.   The important question is therefore not simply which investment has the highest headline yield. It is whether the additional return from high-yield bonds is sufficient to compensate me for taking on credit risk, interest-rate risk, duration risk and market volatility instead of holding cash.

 Portfolio balancing as financial independence approaches

 The move towards a 60/40 portfolio is therefore not simply about chasing yield.   As my financial independence target gets closer, I want part of the portfolio to provide a relatively predictable income stream while reducing the potential impact of a major equity-market correction.

 High-yield bonds sit somewhere between traditional investment-grade bonds and equities in terms of risk. They offer higher income, but that income comes with higher credit risk.

 For me, the comparison with cash is therefore particularly relevant. A fixed-term deposit provides a known return and no market-price volatility during the term, while a high-yield bond fund provides potentially higher income but exposes me to changes in bond prices, credit spreads and defaults.

 The next question is whether the additional yield from high-yield bonds is enough to justify those risks.  For a portfolio designed to reach financial independence over the next 15 years, portfolio balancing is becoming just as important as maximising returns.