Are corporate funds bouncing back?

Most corporate bond funds are now positive for the year and many are close to recovering all the losses seen during March.

Corporate bonds sold off sharply in the first half of March as fears of the long-term effect of the coronavirus and the lockdowns designed to halt its spread finally caught up with markets.

The dash for the cash saw almost all assets fall as investors and businesses desperately tried to raise cash and a loss of market liquidity saw almost all corporate bonds fall sharply in value.

The injection of liquidity by central banks, coupled with new pledges to buy corporate bonds as part of market support initiatives, has seen corporate bond values return to pre-crisis values.

Lagging behind

Since the start of the year the average fund in the Investment Association Sterling Corporate Bond sector has returned 2.52 per cent, compared with -16.35 per cent for the sector average for IA UK All Companies.

However, as the graph below shows, UK Corporate Bonds have lagged UK Gilt funds as on average they have failed to provide as much downside protection during March.

UK corporate bond funds were hampered during the first half of March by the severe shortage of liquidity that made trading difficult.

In addition, the lack of flexibility in fund mandates meant corporate bond funds have had to ride out the market volatility without being able to seek shelter in less affected corners of the bond market or take advantage of price dislocation when markets recovered.

This market should, in theory, have played to the strengths of strategic bond funds, which should have been able to use their greater flexibility to take advantage of the protection of gilts in the early sell-off and profit from the greater sell-off in high-yield bonds and subsequent sharper recovery.

The injection of liquidity by central banks, coupled with new pledges to buy corporate bonds as part of market support initiatives, has seen corporate bond values return to pre-crisis values.

This has not played out in practice, as the IA Sterling Strategic Bond sector has lagged the conventional bond sector in 2020, but one fund that has fully demonstrated the potential returns available for unconstrained bond funds in such volatile markets is Allianz Strategic Bond.

Since January 1, this fund has returned 26.2 per cent compared with the sector average of 1.05 per cent. Managed by Mike Riddell and Kacper Brzezniak, the fund produced strong performance both in the bond market sell-off before fully capitalising on the recovery.

Between February 21 and March 20 the fund was the best-performing fund in the IA Strategic Bond sector, and one of only three funds in the sector to produce a positive return (5.31 per cent). As markets bounced back, the fund produced the second-best returns in the sector, returning 15.54 per cent between March 20 and April 31.

Sell-off

Going into the sell-off the fund was cautiously positioned. The managers increased exposure to sovereign debt and adopted a short position on corporate bonds as corporate bond prices appeared to take no account of the looming coronavirus-linked recession.

As the sell-off unfolded, the spike in credit yields and the huge amount of central bank stimulus saw valuations go from overpriced to very cheap in a matter of days and offered the opportunity to offload some of their government debt to take advantage of the ultra-cheap valuations on offer in the secondary markets.

The fund has increased its credit holding by taking part in the new debt issues from highly rated corporates on very attractive yields.

The lack of flexibility in fund mandates meant corporate bond funds have had to ride out the market volatility without being able to seek shelter in less affected corners of the bond market or take advantage of price dislocation when markets recovered.

The fund has also seen a large inflow of money from investors, which the managers have used to buy new debt issues from lower rated investment grade companies where the managers feel confident the issuers will not see further downgrades.

In very volatile markets, such as those seen recently, you would expect strategic bond funds to outperform given their flexibility and ability to switch between sectors, duration and credit risk.

However, where strategic bond funds are merely replicating the performance of credit markets you may be better off sticking to a specialist corporate bond fund.

Charles Younes is research manager of FE