Corporate bonds are like eggs – perfectly suited for a particular role but fragile when subject to unexpected changes in the environment. As any school science teacher will tell you, the domed top of the egg is incredibly effective at dispersing vertical forces, but if you apply pressure to the side of the egg the result is an unpleasant mess. This similarity between eggs and corporate bonds was brought to mind as I reviewed the returns of cautious funds and portfolios over the year to date.
As at the end of July, the Morningstar Cautious category average has delivered a return of 1.82% over 2021. The Moderately Cautious category has been even more positive with a return of 2.94%. These returns are especially notable in an environment where UK gilts – as represented by a leading gilt ETF – have delivered a negative (NAV) return of -3.08% as cautious funds typically hold 70% to 80% in fixed income.
Corporate bonds played ‘significant role’ in protecting against decline in govvies
Digging more deeply into these returns, it is clear corporate bonds played a significant role in protecting investors from declines in government bonds. At the end of March, according to Morningstar data, the average fund in the GBP Cautious Allocation Category held bonds with a weighted average credit quality of BB and modified duration of 2.6 years.
By contrast, a more traditional mix of assets, as represented by the Morningstar UK Cautious Target Allocation Index, has a modified duration of 9 years and a credit quality of A. This difference in characteristics made a significant contribution to returns as the average GBP Corporate Bond fund posted a return of -0.76% during the first seven months of the year. Though slightly negative, this represents outperformance of 2.32% compared with gilts.
Bullet dodged?
While investors in cautious portfolios may feel they have dodged a bullet, this result can be likened to the downward pressure on an egg. While government bond yields rose, a combination of economic recovery, loose monetary policy and optimistic investors is perfectly suited to corporate bonds – and they behaved as expected.
Although this is a pleasant short-term outcome for cautious investors, it is worth remembering the reason they have typically chosen a cautious portfolio is because they are unwilling or unable to accept significant losses. And the reason these portfolios are typically dominated by bonds is these assets tend to be both less volatile and negatively correlated to equities in times of crisis.
While corporate bonds fulfil the former criteria, they do not offer predictable negative correlation in markets dominated by negative sentiment. This is illustrated by the last decade, which has contained 15 drawdown periods in global equities. Government bonds produced positive returns in 80% of these periods while corporate bonds were positive in 53% of drawdowns.
Greater vulnerability
It is not surprising corporate bonds are more vulnerable to declines in equity prices as the latter tend to occur when investors are concerned the future is more difficult for companies – which naturally raises concerns about the ability of businesses to service their debt. In such situations investors typically demand a higher return in the form of wider credit spreads, which can offset benefits corporate bonds gain from the decline in government bond yields (and rising prices) that typically accompany falls in equity prices.
While it may appear sensible to hold corporate bonds instead of government issued debt in an environment of rapid recovery and higher inflation targets, the role of a multi-asset investor is to create portfolios that are robust to a range of possible outcomes rather than becoming focused on one single outcome.
Eggs and baskets
This point is especially important for managers of cautious portfolios as investors tend to have all of their eggs in one multi-asset basket and cannot afford for those eggs to be broken in the pursuit of short-term relative performance in a rising market.
As we cannot control the forces to which the basket is subject, the contents of a cautious basket are unusually important. In this context, government bonds are more like hard-boiled eggs. While far from invulnerable they are more robust in the event of high levels of volatility. Such characteristics seem of little value in a period when the prices of risk assets are rising rapidly, but the focus of investment must always be to the future when our baskets may be under far greater stress from unexpected directions.
Dan Kemp is global chief investment officer at Morningstar Investment Management
