With the difference between yields on government and corporate bonds narrowing and returns across bond sectors converging so far in 2017, it's a good time for bond fund investors to question whether they're getting paid enough to take risk.
The most commonly used metric for measuring an investment's risk is the volatility of its historical returns. Academics have developed various measures that risk-adjust returns, such as the Sharpe ratio and Information ratio, using volatility as a proxy for risk. Such metrics attempt to gauge whether investors have been compensated adequately for the risks taken.
But how informative are volatility-based performance metrics? During long stretches, volatility can be useful in highlighting certain types of risk. For instance, in periods of economic weakness, high-yield bonds have experienced elevated defaults accompanied by sharp sell-offs.
Local-currency emerging markets bonds have traditionally experienced heightened levels of volatility because of fluctuations in emerging-markets currencies relative to the dollar and the euro. Long-duration European government bonds, which are highly sensitive to small changes in interest rates, have been similarly volatile. But we don't necessarily need volatility to tell us these sectors are risky.
Measuring Risk in Bond Investing
Looking at a fund's credit quality, currency, and duration exposures would give us the same information about those specific risks. Historical volatility is also only as helpful as the period you choose and the specific events that occurred in it—which may not be similar to the risky events to come. For example, the trailing five-year period to August 30, 2017, includes only one stressful period for high-yield corporates: June 2015 through February 2016.
That was mainly confined to energy and metals and mining firms, and affected the U.S. high-yield market, where these sectors play a larger role, significantly more than the European one. Shifting Fortunes Overall, the post-crisis environment of low yields; low defaults; and a drawn-out, tepid economic expansion has rewarded high-yield and high-beta corporates more than all other bond sectors.
For example, over the past five years through August 2017, the Bloomberg Barclays Pan Euro High Yield Index gained 8.1% annualised, versus 4.1% for the Bloomberg Barclays Euro Aggregate Corporates Index. The high-yield index's Sharpe ratio of 1.86, which takes the index's excess returns and divides them by the standard deviation of those excess returns, also outranks other sectors, including the investment-grade corporate bond index. That means that, on the surface, investors were sufficiently rewarded for taking large amounts of corporate credit risk during this period.
But as time periods shift, old events drop out, and new ones enter, volatility-adjusted metrics can change. For a simple illustration of how quickly and dramatically the fortunes of different bond sectors can shift, look at the five years leading up to the financial crisis and the five years that follow
In mid-2007, just as a lengthy stretch of strong performance for credit-sensitive high-yield bond funds began to show the first signs of reversing, the average Sharpe ratios for the EUR High Yield Bond and the EUR Corporate Bond categories far outpaced diversified and government bond funds.
But in the five years that followed, high-yield bond and corporate bond funds went from the best to the worst-performing funds in volatility-adjusted terms. Noting the historically stretched valuations on lower-quality corporate bonds in mid-2007 would have been more useful in warning investors about the risks ahead.
Conversely, government and diversified bond funds went from the worst-performing to the best-performing sectors over the period. Notably, their volatility in the post-crisis period was only slightly higher than the pre-crisis levels – while standard deviation had more than doubled for high-yield and corporate bond funds. In addition, there are plenty of instances where risks pass undetected by performance statistics until it's too late. As we noted in 2008, that was the case for funds that invested in subprime-backed mortgage bonds prior to 2007. Volatility-based metrics signalled that these funds were safe – until they no longer were and the pain had been taken by investors.
Liquidity risk, which is difficult to measure and constantly changing, can be especially difficult to catch by looking at realised volatility, but it is nevertheless a critical consideration for investors in vehicles that offer daily liquidity. Today, large portfolio exposures to issues that aren’t as frequently traded, such as certain asset-backed sectors or heavily subordinated debt, can raise liquidity concerns, even if that risk hasn't shown up in a fund's performance metrics.
Tread Carefully
Given the strong multi-year run for riskier sectors, it's more important than ever to remember that observed volatility alone won't warn you about the risks to come. Bond managers who have been willing to underperform lately, both in absolute and risk-adjusted terms, rather than follow the crowd into riskier territory, may be set up to succeed in the future. Here are some examples of EUR Corporate Bond funds rated positively by Morningstar analysts, and which have been treading lightly in the riskier areas of the markets lately.
BGF Euro Corporate Bond – Silver Rated
Tom Mondelaers has managed this fund since July 2009. He is a senior member of BlackRock’s highly regarded euro fixed-income team, led by Michael Krautzberger. The investment approach centres on building a portfolio of diversified risks and adding value in a consistent, incremental manner through a broad range of primarily relative value strategies. The fund typically invests in over 350 holdings, including small exposures to high-yield, government, and non-euro bonds.
Over the second quarter of 2017, the team reduced risk across the board—the fund’s overall credit risk hit its lowest level since 2014 as the managers took profit on some corporates and trimmed peripheral sovereign bonds. The decision to underweight duration also helped during the rates sell-off in June 2017, adding to the fund’s strong record of risk-adjusted outperformance over the years.
AXA WF Euro Credit Investment Grade – Bronze Rated
This fund, which benefits from a competent team and a lead manager, Eléonore Bunel, at the helm since 2008, employs a diversified and risk-controlled process. Faced with volatility in the credit markets in 2016, the team reduced their exposure to subordinate financials and repositioned part of the portfolio towards senior paper. The portfolio retained only a modest overweighting on financials, concentrated in the insurance sector.
At the same time, the team avoided the cyclical basic-materials and capital-goods sectors, while finding more opportunities in real estate, services, and utilities. Although the fund’s three-year record is muted, over longer periods its cautious approach has paid off for investors.
