Tora: Bond fund yields still look attractive

Brian Tora byline small

Bond funds have been popular for some time – until recently, that is. Demand for these perceived less volatile and income- generating funds was strong in the early part of last year but tailed off sharply as 2012 drew to a close.

According to Cofunds, while they remained an important sector in terms of net sales, the picture changed dramatically in the fourth quarter. Both retail and institutional sales shrank by 4 per cent in the final quarter of the year – not sufficient to put them into negative territory overall (retail funds were up 9 per cent and institutional 8 per cent for the year as a whole), but as clear an indication of a change in sentiment as you could find.

December itself was even more dramatic. Net sales fell 6.5 per cent in the retail sector and a massive 11 per cent for institutional funds. This can prove a revealing contrast. The retail funds are more likely to be advisory, driven by client instruction. Institutional funds, on the other hand, are those controlled by the discretionary fund managers, suggesting they were taking an altogether more negative view of the sector. It does not necessarily follow that they should be any more correct than a DIY investor but they are more likely to act together.

In a way, this is hardly surprising. Much of the sentiment that has developed recently has been more positive for equities and cautious of the outlook for bonds, particularly because of growing concern that inflation will remain above trend for some little while.

Even more important is that an appetite for risk has returned to the investor community. This is owing in no small measure to the fact that many of the obvious pitfalls likely to upset markets have so far been sidestepped. The single currency zone in Europe remains intact. The US fiscal cliff has been avoided.

But the performance of bond funds has held up well. During the second half of 2012 the average corporate bond fund rose 8 per cent if you include reinvested income. The leader over this period returned nearly 15 per cent. And this was at the time that many investors were taking their profits and switching into equity funds which, to be fair, also had a good run. Has this asset class run its course or is there still a case to be made for maintaining a commitment?

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The latest set of inflation figures did not encourage or discourage taking a firm stance either way. Unchanged for the third month in a row, the Consumer Price Index was still significantly above the government’s target, while the Retail Price Index was even higher.

Of itself this does not demand a rethink of the strategy of holding bond funds, though it does make the prospects for equities, with their ability to raise dividends, that much better. Equally, sufficient uncertainties remain in a number of areas to make investors wary of over-committing to more volatile equity markets.

What is clear, though, from an examination of the performance records is that conditions in the corporate bond market have tested the skills of investment managers, leading to some disappointing results from hitherto stars. M&G, as an example, has been a popular home for bond investors, with its core funds attracting billions of pounds. Their more recent performance has been distinctly fourth quartile, with the Long Dated Corporate Bond fund actually tail-end Charlie over six months and one year.

There have been some very consistent performers, though. Baillie Gifford’s Investment Grade Long Bond fund has remained right at the top of the tables for all of the periods reviewed. Fidelity’s UK Long Corporate Bond fund may only feature in the top five over three and five years but is consistently top quartile, though their other bond funds have a patchier record.

It may be those switching out of corporate bond funds into equity-focused ones will be proved correct over time but the evidence is not yet compelling. What is clear is that this is now a very professional market, of a size that allows significant variation in performance between managers. And while sovereign debt funds do not generate significant income returns by and large, the yields on many corporate bond funds are clearly attractive at this time of low interest rates. For many investors, maintaining corporate bond funds in their asset mix will continue to make sense.