Funds buying investment-grade debt are aiming for a quiet life of low risk and relatively low reward. In recent times, however, managers have been confronted by two developments that have threatened to rock the boat: outsized returns and external threats to stability.
In attempting to guard against the latter, the Bank of England (BoE) has twice over the past decade bought UK corporate debt as part of its quantitative easing programme. In doing so, the central bank has helped bolster a rally built on the foundation of rock-bottom interest rates.
But it is not just monetary policy that has affected how the market is viewed by participants and commentators alike. The BoE’s bond buying was briefly restarted just two years ago, in the aftermath of the EU referendum. The Brexit vote brought with it warnings of a different kind: that the domestic debt market might begin to wither away as London’s financial importance dwindled.
Funds in the Investment Association (IA) Sterling Corporate Bond sector can buy debt that is either sterling denominated or hedged back to sterling, so a shrinking market wouldn’t have presented an insurmountable problem for managers, advisers or clients. But Brexit has actually proved a boon of sorts to the market – simply because the weak pound has meant more UK companies are being taken over by foreign rivals. Acquirers often fund these deals by issuing bonds in the currency of their takeover targets, meaning UK issuance levels have remained healthy since the referendum.
That said, there are signs of increased nervousness over the amount of supply in the UK market. FTSE 100-listed Relx (formerly known as Reed Elsevier) was forced to scale back the amount of debt it issued in March – an unusual event that briefly caused ripples of concern in the market. That debt was denominated in euros not sterling, and there have been few alarms since then, but the episode served as a reminder that serene conditions cannot last forever.
Standouts
Table 1, which ranks the top 20 corporate bond funds and trusts over the past five years, shows that the past 12 months have been slightly choppier sailing. But it is hard to make the case that the storm has already arrived: losses have been minimal thus far, and medium and long-term numbers remain very healthy.
As usual, there are caveats that should be observed before turning to the table in more detail. Most significant is the fact that funds which buy long-dated corporate bonds have been excluded. If these offerings were included, the rankings would look rather different. The bulk of the top 10 would be occupied by these funds, which buy debt that will mature in 20, 30 or more years. These funds are more sensitive than most to interest rate rises, and are typically only bought by institutional investors that need to match liabilities.
The flip side of this increased sensitivity to rate hikes is that such vehicles also do better when the bond market is prospering. With the multi-decade bond rally having proved more resilient than most observers expected, long-dated portfolios have topped the charts.
This trend should encourage caution when it comes to other assessments, too. The latest edition of BMO Global Asset Management’s regular FundWatch survey found that, as of July, the Corporate Bond sector was the most consistent of all IA groupings. However, many of the funds responsible were focused on long-duration debt.
Of those portfolios which advisers may consider viable possibilities for their clients, the best is Rathbone Ethical Bond, which has turned £1,000 into £1,358 over the past half decade. Alongside BlackRock Corporate Bond, it also tops the table across 10 years.
As its name implies, Rathbone Ethical focuses on sustainable investing as part of its investment philosophy. But for the generalist corporate bond fund buyer, other attributes are less easy to spot. Chief among these is the credit quality of underlying investments.
To qualify for the Sterling Corporate Bond fund sector, portfolios must hold at least 80 per cent in sterling bonds that have a credit rating of BBB- or higher. This BBB- rating typically equates to the lowest-quality investment-grade bonds. The IA has set the threshold here in order to ensure these funds don’t unduly stock up on even-riskier, high-yield bond funds. Nonetheless, at this ‘late-cycle’ stage, even bonds rated BBB- must be considered more of a risk than they once were.
Yet fund managers have been pushed into buying more debt at this end of the credit scale simply because the yields available on the safest bonds have continued to fall over the past decade. As it stands, the average yield for Sterling Corporate Bond fund managers is 2.8 per cent, according to FE. For the top 20 funds, this rises to 3.1 per cent – a surprising finding, perhaps, given that better performance typically translates into lower yields.
This only serves to emphasise the importance of investigating the creditworthiness of a given portfolio. The same applies to the two index funds in the table – UBS Sterling Corporate Bond Indexed and the popular Vanguard UK Investment Grade Bond Index. Typically, investment-grade benchmarks hold around 40 per cent in BBB-rated debt, meaning they too could prove vulnerable if some of these holdings prove less secure than thought.
For now, funds in the sector have settled into something of a holding pattern. Returns have been underwhelming, but they have not suffered the kind of sharp reverse that so many have feared for so long.
This kind of slow but stable performance is more typical of the bond funds of old. Managers and buyers will be hoping it can continue for a while yet.
