Following a disappointing 2015, 2016 turned out to be quite resilient for corporate bonds. The surprising outcome of the Brexit referendum only had a temporary negative impact on European corporate bonds, as quantitative easing by the European Central Bank continued to support investor sentiment for most of the year. Concerns over the health of European financials and ECB tapering, and the unexpected election of Donald Trump as 45th US president caused credit spreads to widen slightly by the end of the year.
Ultimately, credit spreads were tighter at the end of 2016 than they were at the end of the previous year, but more importantly yields on German bunds and British gilts fell substantially. This low-rate environment was favorable for the construction and real estate sectors, but negative for the financial sector, given the risks affecting financial firms’ profitability.
Still, the main tailwind for UK investors in euro corporates was the stronger euro, which gained more than 16 per cent in value versus the pound sterling over the course of last year. These factors combined fuelled the high absolute returns for the Morningstar EUR Corporate Bond category in sterling terms (20.6 per cent over 2016), while the GBP Corporate Bond category returned a more modest 9.7 per cent.
Top picks in the euro corporate bond space
Schroder ISF Euro Corporate Bond was upgraded to Bronze from Neutral in December 2015. The credit team at Schroders was part of a large reorganisation in 2012. Experienced credit portfolio manager Patrick Vogel joined as head of European credit and fund manager for the strategy. Vogel changed the investment process to a themes-based approach, with increased involvement of the credit analysts. Since then, the analyst headcount has also increased, which we believe to be positive and key to the new investment style. The robustness of the process and value-adding credit research capability have resulted in a significant improvement in performance under Vogel.
Silver-rated Invesco Euro Corporate Bond fund has been run by Paul Causer and Paul Read, co-heads of Invesco Perpetual’s fixed-income team, since its launch in 2006. Their approach is entirely benchmark-agnostic, with no formal limits on sector and country weightings. Bets on individual issuers can also be substantial: the flexibility of the process can trigger periodic bouts of underperformance, but Causer and Read have been able to use it to investors’ advantage over the long term. Over 10 years to the end of January 2017, the fund has outpaced 97 per cent of its competitors as well as the Barclays Euro Aggregate Corporate Index.
As part of a broader push of expanding its research coverage to include ETFs, Morningstar assigned a Silver rating to iShares Core € Corporate Bond in November 2016. We consider it to be a compelling investment option to gain broad-based access to the market of euro-denominated corporate bonds. The fund tracks the BBgBarc EUR Aggregate Corporate Index that applies a more flexible set of eligibility criteria than benchmarks used by other ETFs and its tracking record is good. Overall, our view is that over a full market cycle, this low-cost passive approach is compelling in the very competitive euro corporate bond space.
Top picks in the sterling corporate bond space
Invesco Perpetual Corporate Bond is co-managed by Paul Causer and Michael Matthews, who run a benchmark-agnostic approach. Matthews, who has been part of the team since its start in 1995, was named co-manager here in 2013. Paul Read relinquished his responsibilities as comanager of this fund effective January 2017. The implementation of the fund’s bold approach has seen the managers retain a significant underweight duration stance in the past few years. However, despite the underperformance caused by this positioning in the recent past, the managers’ experience and the effectiveness of their high-conviction approach over the long term gives us comfort.
Royal London Corporate Bond fund, rated Silver by Morningstar, is run using a collegial team-based approach led by fixed-income veteran Jonathan Platt. Platt assumed sole leadership of the fund in May 2015 after co-manager Sajiv Vaid’s departure. He had co-managed the fund since its launch in March 1999 and has been instrumental in developing the firm’s fixed-income expertise and shaping the fund’s investment approach. The fund’s investment process starts with a review of the macroeconomic environment, followed by in-depth bottom-up credit research. Overall, a time-tested process established and executed by a seasoned manager and backed by an experienced and collegial team drives our positive view on the fund. Additionally, below-median fees add to its appeal.
The Silver rated iShares Core £ Corp Bond fund shows a very tight tracking record relative to the Markit iBoxx GBP Liquid Corporates Large Cap Index, which comes in just a few basis points below the ongoing charge of 0.2 per cent. GBP-denominated corporate bonds tend to have much longer maturities than their euro-denominated counterparts. This ETF’s duration, that stands currently between eight and nine years, makes it more likely to experience capital losses in the event of rising interest rates, than active peers with an ability to reduce duration risk. Even accounting for this, we take the view that this ETF has the ability to outperform category peers over a full market cycle.
What drove performance?
For sterling corporate bonds, 2016 proved to be a difficult year, with the category average (9.7 per cent in GBP terms) significantly underperforming the category index, the BBgBarc Sterling Aggregate Corporate (13.25 per cent). Funds in the EUR corporate bond space fared better in absolute terms in part due to the weakening of the pound versus the euro. However on average (20.6 per cent), they still underperformed the BBgBarc EUR Aggregate Corporate Index (21.3 per cent), though to a lesser degree than their GBP corporate bond peers. Corporate bond managers who anticipated higher interest rates by underweighting duration struggled. Silver-rated Invesco Perpetual Corporate Bond and Invesco Euro Corporate Bond both landed in the bottom performance quintile of their respective categories as their short-duration bias in a falling bond-yield environment turned out to be a key detractor.
Manager preference for the financial sector didn’t do much good either, as banks and insurance companies underperformed the other sectors over concerns over their financial health and the negative impact of low interest rates on profitability.
Royal London Corporate Bond’s underweight duration stance also held the fund back, along with the fund’s bias to senior bonds, which have lagged riskier credits. Sector allocation did work out positively, landing the fund in the second performance quartile of its Morningstar category.
On the other hand, the Schroder ISF Euro Corporate Bond, rated Bronze, stayed ahead of both its category peers and its index, partly by being underweight financials. The overweight credit beta also contributed positively while credit spreads tightened, as did the overweight in real estate companies in a bid to benefit from quantitative easing in Europe.
All in all, while 2017 might prove to be a choppier market for corporate bonds than the year gone, we remain fully confident in our positively-rated funds in this space. We encourage investors to take a long-term view on performance and not overreact to short-term returns. Our research shows investors trading frequently in and out of funds tend to miss out on a large portion of performance over time; investors who stick to their strategic allocation without giving in to the temptation of market-timing their investments typically reap higher returns over a full market cycle.
23% Annual return of the Schroder 1st Euro Corporate Bond in 2016
20.6% Return of the Morningstar EUR Corporate Bond sector in 2016
97% Percentage of funds the Invesco Euro Corporate Bond fund has beaten over 10 years
2017 Year Causer and Matthews assumed control of the Invesco Perpetual Corporate Bond fund
European corporate bonds proved resilient in 2016, with the stronger euro the main tailwind for investors. However, they slightly underperformed the index, with funds that underweighted duration or with exposure to financials struggling.
Niels Faassen is an analyst for manager research at Morningstar.