Fitch warns investors to ‘carefully review’ bond funds

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Fitch Ratings has called on investors to review the investment processes of bond funds to ensure their discipline and flexibility is being preserved in the search for yield.

In its latest income fund report, the ratings notes that investment in yield-generating assets is likely to continue against a backdrop of moderate economic growth and sound corporate fundamentals, as well as investors’ search for regular income and low volatility.

However, it adds: “Investors should not overlook that total returns in the recent years were largely driven by capital gains. For example, two-thirds of 2012’s total return in investment grade indexes came from spread and interest rate compression, and income only accounted for a third.”

“At this point in the interest rate cycle, investors should not extrapolate recent returns and conversely look at the growing risks, which the recent market volatility confirms. Duration risk is relatively higher at this point in the cycle as only 40 basis points of increase in interest rates offset the yield of typical developed market investment grade indexes.”

Fitch also points out that most income funds concentrate on BBB and BB-rated corporate issuers, although it highlights a trend for looking at B-rated or lower issuers, which “significantly” increases default risk.

The ratings agency warns that income strategies are likely to be challenged in four areas: flexibility, discipline, bottom-up research and market risk mitigation.

Fitch says flexible mandates with unconstrained processes are better positioned for the current climate, as they are able to “capture yields commensurate with the risk taken and can opportunistically shift from an asset class to another”. It gives the example of being able to shift from bonds to equity as the yield on high yield bonds and high dividend stocks has become so close.

Disciple is highlighted as Fitch stresses the need for funds to concentrate on company quality and avoid being dragged down the credit curve as portfolios are reinvested in lower yielding assets. It also says asset managers should show discipline in managing investor expectations by preparing them for the fact recent returns are not necessarily repeatable.

In addition, the commentator says funds with better analytical resources for their bottom-up research will be better positioned than their peers while noting that open ended funds cannot escape market risk.

“Investors should carefully review the investment processes of income funds, to ensure discipline and flexibility is maintained in the search for yield,” Fitch says. “The recent market volatility also reinforces the importance of mitigating market risks.”