According to the IMA, the Sterling Corporate Bond sector was the worst selling sector in July (based on net retail sales) this being the eighth month running that the sector has seen outflows. Over recent months there has been talk of the "Great Rotation" out of bonds into stocks as government bond rates rise from record low levels but monthly inflow data can be misleading.
It is therefore helpful to consider the journey that the corporate bond asset class has experienced over recent years. Government bond yields reached record lows with the yield on the 10-year UK gilt hitting 1.4% in July 2012 whilst corporate bond spreads experienced significant compression. The search for yield combined with unconventional monetary policies have pushed spreads lower, and this has increased the correlation of corporate bonds with government bonds, and therefore their interest rate sensitivity. Over this period, UK corporate bond funds experienced significant inflows and UK corporate bond indices delivered double digit returns in 2012.
Following this period of strength, going into 2013 a number of managers we spoke to had increasingly mixed view on the corporate bond asset class believing that yields and valuations had become unattractive. Indeed, while 2013 started on a strong note with improving investor sentiment and on-going liquidity provided by the Central Bank, it was riskier bond assets such as high yield that were preferred in the fixed income spectrum.
Since the 22nd May and US Federal Reserve chairman Ben Bernanke's comments that bond purchases could slow down by the end of the year given the improving macroeconomic situation in the US, fixed income markets have seen considerable volatility. Government bonds were directly impacted by the yield rise, with bond markets suffering outflows across the fixed income spectrum. The 10-year UK Treasury yield rose from 1.90% to 2.79% (22nd May to 30th August 2013). Investment grade bonds which have longer duration profiles and relatively low yield levels were also impacted with the IMA Sterling Corporate Bond sector down around 3.7% over the same period. High yield bonds fared better over this period as the asset class’ short duration characteristics meant it was less sensitive to a rise in interest rates.
After the second quarter sell-off, bond markets stabilised in July. A number of managers we speak to started to add fixed interest credit risk back into their portfolios through investment grade and high yield bonds as relative values had improved with fundamentals slowly starting to re-assert themselves. From a technical standpoint, in spite of retail fund outflows, a number of global pension fund surveys in 2013 highlighted that pension funds were still looking to buy corporate bonds and that their allocation to the asset class within their broader portfolio could rise. Indeed, there is much talk of pension funds continuing to de-risk which could lead to higher allocations to credit being supportive of the asset class. The consensus view is that bond yields are expected to stabilise at higher levels but interest rate rises may remain a long way off in the US as the recovery is still in a fragile state. In addition, other major economies such as the UK and Europe are still in a delicate state and cannot afford to see interest rates move up. Indeed, any disappointment to growth expectations or unforeseen economic events could see yields ease back in the short-term.
Within the IMA Sterling Corporate Bond sector we are mindful that the largest five funds account for around £23 billion between them and that some of these portfolios have either moved to stem flows or are currently experiencing modest outflows. The potential for liquidity problems in the credit market and its impact on corporate bond funds is a subject that we have monitored since 2008 and we have regular discussions with managers on the steps they are taking to adjust their approach for a lower-liquidity environment.
We are aware that our high conviction recommendations in the sector include four of the largest funds in the sectors, namely Fidelity Moneybuilder Income, Invesco Perpetual Corporate Bond, M&G Corporate Bond and M&G Strategic Corporate Bond. These funds are managed by impressive investment teams with well-established and repeatable processes and have therefore held Morningstar OBSR Analyst Ratings for a number of years.
There are a number of smaller funds in the universe that are also managed by established and experienced team who combine credit research within a broader macroeconomic context. In our view, Kames Investment Grade Bond and Royal London Corporate Bond, which respectively have Morningstar OBSR Analyst Ratings of Silver and Gold, stand out as compelling offerings for investors. Both funds under-performed the sector average in 2008 but we believe their teams have proven their ability to adjust their approaches in the wake of the credit crisis, while maintaining their distinctive process.
In addition, Ignis Corporate Bond which has a Morningstar OBSR Analyst Rating of Bronze, BlackRock Corporate Bond and Old Mutual Corporate Bond are interesting offerings for investors. All three funds since 2008 have either experienced changes to their management teams and or investment process. In our view, the funds are managed by knowledgeable fixed income practitioners and well-resourced teams that have built comprehensive investment approaches. Ignis Corporate Bond combines macro analysis with detailed credit analysis and the manager has shown a willingness to be flexible in the face of changing macroeconomic conditions.
This article first appeared on IFAOnline.co.uk
