Assets Flowing into UK Corporate Bonds
According to the Investment Management Association (IMA), the sterling-denominated corporate bond sector has led the way in net retail flows every month this year except March. Buoyed by this weight of money, UK corporate bond indices returned nearly 10% over the first eight months of the year. Yet these flows have led M&G to restrict inflows into its corporate bond strategies and served to increase focus on a sector where liquidity concerns many investors and remains a focus of the Financial Services Authority(FSA). It therefore seems an opportune time to consider the health of the asset class and highlight some of the funds available to investors.
A Mixed View for the Asset Class
Following a period of strength, the managers we speak to now have increasingly mixed views on the outlook for the asset class. The difficulty, of course, is in setting asset class expectations in an environment where the “risk-free” rate is distorted by central bank policies and there is a degree of nervousness at the low yields now being paid by corporate issuers, with the potential for capital loss should government bond yields rise meaningfully.
However, fund managers are equally aware that quantitative easing policies are designed to suppress sovereign borrowing costs and force investors to continue buying riskier assets such as corporate bonds. As a result, many funds remain overweight credit risk but this position is very differently constructed across the universe; some investors are positive on the value offered by higher-risk bank bonds, while others prefer to focus on more stable, defensive sectors despite their increasingly tight yield spread over gilts.
If quantitative easing policies do indeed continue to encourage significant inflows into corporate bonds, the liquidity of the asset class will remain a key focus for many commentators. The potential for liquidity problems in credit markets and its consequent impact on corporate bond funds is a subject that we have monitored since 2008 and continue to discuss actively when analysing funds in the sector.
The Liquidity Issue
We saw in 2008 that liquidity can dry up in this over-the-counter market and if the significant inflows to the asset class since 2009 are rapidly reversed – as could happen if negative returns are delivered in a rising-rate environment, even if credit spreads tighten – there is the potential for another challenging environment. We would nevertheless note that this is a multi-faceted debate, not least because demographic factors might suggest that much of the demand for corporate bonds is structural rather than speculative, and it is far from certain that we are sowing the seeds of another liquidity crunch. Our approach is therefore to discuss with fund managers the steps they are taking to adjust their approaches for a lower-liquidity environment, which often incorporate holding a larger liquidity cushion and a greater focus on on-the-run bonds, and to consider such factors as part of our fund analysis process.
This is a particularly important issue given the concentration of assets within the sterling-denominated corporate bond universe. The largest five funds account for a colossal £24 billion between them, not far off half the money invested in the whole sector. In part, this reflects the paucity of mainstream corporate bond fund launches over recent years, with many groups preferring to focus on strategic bond funds. It is also a manifestation of the 2007-08 credit crisis, an extreme shock to corporate bond markets that resulted in significant performance dispersions and has subsequently led to assets gravitating towards those funds that held up relatively well over the period.
High-Conviction Funds: The Behemoths
In this vein, we are mindful that some of these behemoth funds are where we are placing our highest conviction ratings. We have high hopes for the Gold-rated Fidelity MoneyBuilder Income fund (
Premium Research), the Gold-rated Invesco Perpetual Corporate Bond fund (Premium Research), the Silver-rated M&G Strategic Corporate Bond fund (Premium Research), and the Silver-rated M&G Corporate Bond fund (Premium Research).
These are funds that, in our view, are managed by impressive investment teams with clear and repeatable processes; they have therefore held high Morningstar OBSR Ratings for many years and have justified our conviction over the exceptional market conditions of the past five years. We typically view the Fidelity and M&G funds as more core holdings, benefiting from the strong combination of extremely well-resourced analyst teams and experienced fund managers with a flair for both macroeconomic analysis and portfolio construction.
High-Conviction Funds: Smaller Offerings
Our preferred propositions amongst the smaller funds in the universe are also run by established teams with significant capacity for placing their company research within a broader macroeconomic context. This reflects both the key ingredients for success in the asset class and the relative dearth of active fund launches in the sector over recent years, as discussed earlier.
In our view, the Gold-rated Royal London Corporate Bond fund (Premium Research) and the Silver-rated Kames Investment Grade Bond fund (Premium Research) stand out as compelling offerings for investors. Although both underperformed the sector average as the credit crisis intensified in the second half of 2008, we believe their management teams have proven their ability to adjust their approaches in the wake of the underperformance, while retaining the core of their distinctive processes. They have subsequently navigated their portfolios well through subsequent periods of volatility.
High Conviction Funds: Niche Opportunities
In addition to more traditional corporate bond funds, the sector contains a small number of more specialist mandates. Of these, we have high regard for the Bronze-rated Monument Bond fund (Premium Research), managed by TwentyFour Asset Management. This boutique boasts significant expertise in the niche sector of residential mortgage-backed securities (RMBS), supporting a fund that invests solely in higher-quality RMBS issues. Although the managers are in the process of trying to widen the investment universe to cover the whole investment grade spectrum, from its current exclusive focus on AAA- and AA-rated issues, we believe the managers will retain their conservative investment philosophy. Although it is a niche offering, we have high conviction in the managers’ ability to deliver its objective of an attractive income relative to interest rates and a total return over the longer term as a result of a comprehensive bottom-up process.
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The original version of this article was published in October 2012 on IFAonline.co.uk.
