Like many sectors, returns in the corporate bond market have rewarded investors for their time spent in it since the financial crisis. From a regional perspective, the sterling corporate bond market has been most profitable, with returns of almost 60 per cent since 2010, inclusive of 10 per cent plus returns in three of the past five years. That said, performance in 2013 and 2015 was admittedly rather fallow, and the first nine months of this year have delivered returns closer to expectations of just 3 per cent.
As always with corporate bonds, the drivers of returns can be split into three broad components: the income paid on the bonds, the rate of return on government bonds and the performance of the bond’s spread. The period 2010 to 2017 has seen a perfect storm of returns in all these areas.
Firstly, the corporate default rate in the UK has remained relatively benign over this period, resulting in the income payments on corporate bonds continuing unabated.
Secondly, the return on a 10-year UK government bond has fallen from 4 per cent at the start of 2010 to 1.4 per cent on 29 September 2017. Such a fall results in the price of sterling corporate bonds rallying, as some investors look to generate the returns they once received in government bonds by investing in corporates.
Thirdly, the spread component of the corporate bond market, as measured by the Bank of America Merrill Lynch Sterling Corporate index, has reduced from 2.1 per cent to 1.3 per cent over the same time period, albeit with some oscillation. Such a trend down again results in the corporate bond market rallying.
All that said, such structural tailwinds for the market would appear near exhausted. The average yield on a sterling corporate bond index has fallen from 6 per cent in 2010 to 2.4 per cent in September 2017. Market expectations of UK interest rate rises this month and beyond are rising and the likelihood of UK corporates further improving their credit quality must be under question.
The sector continues to provide income; however, the more than 10 per cent annual returns are behind us for now.
To that end, we like active managers with a continued focus on income but not to the detriment of capital preservation, proven ability in credit selection and some flexibility to manage interest rate risk where possible.
For the cautious investor, we recommend the Fidelity Moneybuilder Income fund. Given the fund’s investment process and focus on risk, this strategy tends to perform in a relatively defensive manner in comparison with its benchmark. This style of management is particularly helpful during times of market stress, such as was seen during the financial crisis of 2008/9 when the fund exhibited a far less volatile returns profile than the wider market. Mana-ger Ian Spreadbury is clear credit risk assessment is where he can add greatest value and therefore interest rate risk will usually be broadly similar to that of the benchmark.
For investors willing to take on a little more credit risk, we recommend the Kames Investment Grade Bond fund. The fund’s managers are part of an experienced and well-regarded fixed income team and we value their proven process which has delivered good returns over time. The managers employ a high conviction strategy with a focus on taking on credit risk where they feel it is rewarded.
For investors wanting a very defensive corporate bond fund, we recommend the Axa Sterling Credit Short Duration Bond fund. A relatively simple fund, it invests in short-dated bonds that produce an income but with less volatility than the market. The income of the fund is likely to be lower than the corporate bond universe as a whole due to the lower maturities of the bonds held and thus the lack of term premium available.
About 20 per cent of the portfolio matures each year, which also gives some protection against any future rises in interest rates, as the manager should be able to re-invest maturing bonds at higher yields. The fund is perhaps most suitable as a cash substitute for investors who are willing to tolerate a higher level of volatility than cash, but be rewarded with a higher income over time.
Paul Angell is investment research analyst at Square Mile