Corporate bonds offer low-risk, steady results over the long term – but spectacular performance is rare and seeing opportunities for superior returns is beyond the skill of most asset allocators.
Corporate bonds have not been the easiest of areas in which to invest successfully. Tainted by the credit crunch and the propensity for banks to package up loans for re-sale to other institutions, the risk premium on corporate debt rose sharply, deterring investors and making the life of the specialist manager more difficult. And, of course, inflation re-emerged to add yet another negative influence to this asset class.
Yields, overall, have improved, certainly relative to gilts. The time to look again at corporate bonds could hardly be better. Until the end of August there were two Investment Management Association (IMA) sectors that encompassed the type of security likely to be of interest to those seeking the higher returns available from non-sovereign debt: UK Corporate Bond and UK Other Bond. These two have been split into three new sectors: £ Corporate Bond, £ Strategic Bond and £ High Yield. The £ Strategic Bond sector allows convertibles, preference shares and permanent interest bearing shares. £ High Yield requires more than 50% to be in below BBB-minus issues – junk bonds to the rest of us. It is with £ Corporate Bond that we need to be concerned.
The value attached to corporate bond issues has much to do with the perception of risk. Are Unilever or Shell ever likely to default on their bonds? Not a prospect that many would consider high. But the truth is that yields on these corporate bonds are always likely to be higher than on equivalent government-issued paper, while the way in which each are priced will depend on how investors view both the overall strength of the corporate sector and the attraction of government-backed bonds.
The turmoil in fixed income markets has led to a flight to quality, driving yields down on gilt-edged stocks despite the prospect of commodity-led inflation. Indeed, net yields on conventional gilts are negative on an inflation-adjusted basis, suggesting investors are happier to effectively lose money in an investment secured by government backing than accept a positive return from a security where no such guarantee exists, even if the chance of default is minimal.
Conditions are settling to a more normal pattern, but it has been difficult for the managers of those funds that fall into this category to achieve anything other than a modest benefit from the peculiar circumstances. Indeed, examining the performance tables for corporate bond funds suggests this is a sector where periods of significant wealth generation are few and far between. Income – and lower volatility – remains the only real justification for buying these funds.
Over the short-term six-month tables, during which time conditions have settled down, the average fund is down in value, even after allowing for income accrual. Even the best-performing funds needed their income flow to deliver a positive performance.
Longer term and the picture remains less than enchanting. One-year performance tables still show a negative outcome for the average fund and a return that is still heavily reliant on income for those that are top of their class. Three years and it is hard to see any real difference, with the average fall greater than that of the one-year table. A positive return overall is achieved after five years, and even then there are some funds that will have lost you money.
There have been times in the past when corporate bonds have proved a particularly rewarding area in which to be involved. When inflation comes down sharply, such as in the late 1990s, the pick-up in capital values can be dramatic. But in a world where such influences are under greater control, and in which research into, and evaluation of, the relative merits of individual bond issues has never been greater, gaining that little extra uplift in performance has become much harder to achieve.
Some groups do come through as having developed a franchise in this area. Both the M&G funds that fall into this sector are consistent top quartile performers. Rensburg, too, has maintained a consistency of performance that is worthy of recognition.
Marlborough, on the other hand, has drifted down to fourth quartile in the short-term tables, from a top-10 place over five years, demonstrating that superior skills in equities do not necessarily travel. This remains a sector for which the real reason for being must be the need to generate a high, sustainable income and to reduce volatility, rather than to deliver superior capital performance.
It will always have a following, but for those with a long time-horizon, equity funds continue to look a better bet. That periods will arise when this sector provides superior returns is inevitable. Spotting them in advance, though, is beyond the skills of most asset allocators.