Interest rates
It is a question of when rather than if interest rates rise, and this is generally bad news for corporate bonds. However, different duration bonds will react differently. If you look at the sector’s top performers over the past one, three and five years, long-dated corporate bonds dominate. Being more interest rate sensitive, they have benefited from the ‘lower for longer’ rate environment.
However, if we were to see concerns of a tightening in interest rates, these funds will come under the most pressure. While the solution should be to move towards short-dated bond funds whose capital prices are also less sensitive to interest rate rises and whose level of income remains steady, returns from short-dated corporate bonds have been uninspiring over the past five years. While the top-performing long-dated funds have generated over 50%, short-dated funds from M&G and Axa returned around 10% over the same period.
A question of risk
As well as taking on interest rate risk, corporate bond fund managers have been rewarded for taking on credit risk as the environment has improved and default rates have fallen. As bond prices have appreciated and yields have fallen, it is imperative that the rewards merit the risk taken. At the highest-quality end of the spectrum you are resigned to receiving a similar return to gilts. For example, Standard Life AAA Income currently yields around 1.8%. With global economic conditions improving, I expect defaults to be low and investors rewarded for taking on extra credit risk.
Amid such uncertainty, companies are being fiscally prudent, which is a good attribute for bond investors. Managers Paul Read and Paul Causer have 25% of the Invesco Perpetual Corporate Bond Fund invested in bank debt. Although the lower-rated areas of the corporate bond market do carry greater credit risk, it has traditionally been less sensitive to rising interest rates.
Inflation or deflation?
Like interest rates, inflation is bad news for most corporate bond investors as it erodes the purchasing power of the fixed interest received. The unstable backdrop in the global economy and the unknown effects of quantitative easing mean the inflationary backdrop remains highly unpredictable at the current stage of the cycle. It does seem there is little inflation expectation priced into bond markets.
Generation income
Corporate bond funds are favoured by investors for whom getting an attractive, immediate income is a priority. However, this will push you towards the long-end of the curve, which still provides some attractive income opportunities, with long-duration corporate bond funds yielding around 4%.
However, at the other end of the spectrum, yields on short-dated corporate bonds are below 2% and it is hard to justify their risk/reward trade against holding cash. If an income is not your main priority and you are much more focused on capital growth potential, it is probably worth reconsidering your corporate bond exposure and looking elsewhere within other balanced investment areas.
