When constructing a well diversified balanced or cautious investment portfolio, a significant slug of corporate bonds has traditionally been a staple part of most allocators’ asset mix. Since the onset of the global financial crisis, the climate of low interest rates has provided an excellent backdrop for corporate bonds and the sector has produced some extraordinary returns.
While the strongest returns were delivered during the early stages of the recovery for credit, returns over the past five years have remained compelling, with the best-performing funds in the sector returning over 50% through a combination of income and capital re-ratings. The sterling corporate bond sector remains the dominant place to invest for UK retail investors wanting fixed-interest exposure and is by far the largest of the bond sectors with more than £55bn invested.
However, we all know past performance is no guide to future returns and at the current stage of the cycle this certainly seems to be the case with corporate bond funds. We have witnessed a huge wall of money flowing into bonds from income-starved investors in the past few years. As a result, bond yields have driven downwards and valuations across much of the asset class do not look enticing in absolute and historical terms after several years of strong returns.
With a more challenging environment for fixed interest, many fund selectors – be they DIY investors, advisers or wealth managers – prefer a more flexible approach, whereby deciding where to find value across the bond spectrum is decided by the fund managers. As a result, the rigidity placed on funds within the IA Sterling Corporate Bond sector could prove a hindrance compared with the strategic bond sector, where many managers operate a ‘go-anywhere’ approach across global bond markets.
The challenges facing the sector are highlighted by a steady level of outflows that we have seen recently. This has particularlybeen the case for some of the biggest retail offerings seeing outflows as investors have concerns over liquidity and a preference for smaller funds and more flexible bond mandates. For example, one of the largest UK fund groups, M&G Investments, has seen billions of pounds flow out of its flagship sterling corporate bond funds.
Under review
It would be wrong, though, to completely ignore a sector with just under 100 funds that provide a wide range of strategies across the asset class. The spreads have widened versus government bonds in recent months and that is creating some value in relative terms. I am not convinced there is a bubble in bond markets that is about to burst.
It seems unlikely that UK interest rates are going to rise in the near future and, when they do, it is likely the rises will be gradual. However, there is no doubt that the easy money has been made in this asset class and at the current stage of the cycle it is imperative to review the corporate bond exposure you are holding in your portfolio. So what are the key issues you should be considering when assessing the corporate bond sector?
