Similar to other traditional asset classes, UK-based bond investors have enjoyed a steady ride since the global financial crisis. Credit investors have enjoyed stronger gains as they benefitted from a decline in the spread between the yields for investment grades and UK government bonds. In addition to companies repairing their balance sheets, yields also declined due to the technical support provided by the bond purchase programmes launched by central banks across the world.
Credit spreads widen globally
Sterling credit bond investors got caught by surprise twice this year, as bond markets sold off in February and over the summer. The ICE BofAML Sterling Corporate & Collateralized index has dropped -1.87 per cent so far this year, having registered a maximum drawdown of -2.73 per cent. Although the Bank of England (BoE) raised its benchmark interest rate in August to its highest level since the financial crisis, the main reason for the sell-offs in credit markets must be found overseas.
Credit spreads have widened across the globe as investors worried about the impact of trade tariffs on companies’ earnings. In the US, credit investors had further concerns about the increase in the financing cost for companies as short-term interest rate levels moved above three per cent. In Europe, the Italian election forced market investors to reassess the valuations for Euro-labelled bonds, with Italy being the largest Eurozone bond market.
Low beta fixed income sectors
Have fund investors been protected from this downside? Historically the IA Sterling Corporate Bond sector is one of the safest sectors, as measured by the sector’s beta relative to the underlying asset class. Also, in the past, the beta of the sector relative to the ICE BofAML Sterling Corporate & Collateralized index has ranged between 0.5 and 0.8. In other words, it means that for every one per cent decrease or increase in the index, the sector makes up between 50 and 80 per cent of this move. Therefore, it was expected for the 93 funds registered in this sector to do better as sterling credit markets sold off.
IA Sterling Corporate Bond sector beta vs the benchmark
After the exclusion of long-dated corporate bond funds (due to higher sensitivity to interest rates) and passives, it was surprising to see that 41 funds in the sector registered a poorer maximum drawdown than the benchmark. A few of the big names also got caught in this sell off, such as the M&G Strategic Corporate bond, Kames Investment Grade and Liontrust Sustainable Future Corporate Bond fund. Their downside participation on a year-to-date basis stands above 100, while they have historically ranged under that threshold.
Maximum drawdown in the IA £ Corporate Bond sector
| Name | Size | 2018 max drawdown |
| Scottish Widows Corporate Bond G Acc | £3,510,417,452 | -3.86 |
| M&G Global Corporate Bond IH Acc GBP | £57,864,870 | -3.43 |
| Insight Corporate Bond Instituitional W Acc GBP | £28,814,346 | -3.33 |
| Liontrust Monthly Income Bond B Gr Inc | £372,079,086 | -3.12 |
| BNY Mellon Global Credit W Hedged Acc GBP | £427,305,972 | -3.10 |
| Barclays GlobalAccess Global Corporate Bond M Dis GBP | £570,500,000 | -3.05 |
| Royal London Corporate Bond Monthly Income Trust A Inc | £323,124,155 | -3.00 |
| UBS Sterling Corporate Bond Indexed C Grs Acc | £244,900,000 | -2.99 |
| UBS Corporate Bond UK Plus B Gr Acc | £508,200,000 | -2.75 |
| Schroder All Maturities Corporate Bond Z Acc | £772,253,035 | -2.74 |
Source: FE Analytics
Duration and credit quality
How do we explain this poor performance? Stereotypically, investment grade fund managers have positioned their portfolio with an underweight duration relative to the index. It is the main reason why the beta for the sector looks so low – very few active credit fund managers took the same duration risk as the benchmark.
The key issue this year was not the duration positioning, but the amount of credit risk active managers took. The credit quality of the index has deteriorated over the recent years, as the allocation to BBB-rated bonds increased. Many active fund managers followed the same path and increased their credit risk significantly. Valuations for sterling investment grade bonds have remained compelling, especially relative to their euro and US dollar peers after the EU referendum. With little signs of an economic slowdown, fund managers also expected companies to enjoy stronger earnings and to improve their capacity to repay their debt.
Although the interest rate levels have increased this year, credit fund investors have failed to protect capital as they have built a high amount of credit risk in their portfolio over the recent years. As many of them have maintained their positioning and have not crystallised their losses, we believe investors must now, more than ever, be attentive to the credit risk before allocating inflow to these funds.
Charles Younes is a research manager at FE
