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Scanning the IMA's UK Corporate Bond Sector

A pick for the long-haul.

Stephen Marriott, 10 December, 2007 | 9:24AM
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An initial glance at the best and worst performing funds in the UK Corporate Bond sector would suggest that there isn’t too much to differentiate them. Of the 89 funds that have performance histories of at least one year yields are not too dissimilar: the average yield of the top quartile funds is 4.5%, which compares to 4.1% for fourth quartile; fundamental risk as portrayed by the split between bonds and cash, is not significantly different, and the difference in coupon of the bond portfolios is marginal at 0.02%. However, there is a disparity in terms of risk and returns. This becomes clearer when we look at performance over three years: the top managers

have outperformed their bottom quartile peers by an average of 1.9% per annum (to 31 October) but are no riskier (as defined by the standard deviation of returns). And the same group of top performers have also held up better in what has been a difficult twelve months for bonds, falling by 0.6% compared to -2.6% for the bottom quartile. So what has been driving returns for the top performing set?

There is a difference of 0.3% in the total expense ratio - this may not sound huge, but when returns are trickier as is currently the case, with the credit crunch continuing to affect bond markets, charges become more important. But costs don’t explain everything.

Interestingly, the better performing funds generally have a higher weighting to BBB investment grade bonds – an area of the market which has suffered more than their higher rated A+ grade peers, as credit spreads widened during the recent turmoil. Naturally a higher weighting to BBB bonds proved positive in 2005, which was a good year for bonds, with the top quartile group outperforming the lower quartile funds by an average of 1.3% per annum. However, one would have expected the BBB exposure to have been harsher to recent performance.

By combining active management with portfolio diversification the top managers appear to have steered a smoother course. A number of funds raised portfolio duration into weakness and some were even brave enough to dip their toes back into the banking sector, which although had undergone a sell-off experienced a rally in September. Examples include Gartmore Corporate Bond Fund and Baillie Gifford Investment Grade Bond Fund. Also some funds have raised cash and on average hold 9% of their assets in cash compared to 3% for the worst performers. Additionally the best performers have limited their risk to individual credits by holding on average some 35 more holdings and generally have less concentrated top ten holdings.

An unconstrained mandate is necessary to pursue such a strategy and one manager that has made the most of a flexible process is Stephen Snowden for Old Mutual Corporate Bond Fund. Historically fund turnover has been high as the manager has rotated his portfolio into those sectors and credits where he perceives there to be good value and this has led to top decile performance over three years. This approach can lead to aggressive sector bets and currently the fund has a 22% weighting in banks as well as 7% in real estate, which has knocked performance over the shorter term. Nonetheless, Snowden has an excellent long term track record and those investors looking to maximize returns from corporate bonds should find this fund to their liking.

A version of this article previously appeared in Investment Adviser, Financial Times Ltd.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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