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Are giant bond funds really that dangerous?

14 August 2014

The FCA has warned about the dangers of giant corporate bond funds, but data from FE Analytics suggests that size hasn’t really affected returns in the past.

By Alex Paget,

Senior Reporter, FE Trustnet

Giant corporate bond funds have had just as much chance of outperforming than their nimbler rivals in recent years, according to FE Trustnet research, calling into question worries over capacity and liquidity in the sector.

Being small and flexible has been a big advantage in recent years particularly in equity sectors, as a recent FE Trustnet study highlighted.

However, our data suggests that the size of giant bond funds in the IMA Sterling Corporate Bond sector has had no impact on their ability to outperform.

According to FE Analytics, an equally weighted portfolio of the 10 largest funds in the sector, as of August 2009, has returned 42.21 per cent over five years.

While that composite portfolio has underperformed the 10 smallest portfolios over that time, it has only fallen short by 0.53 percentage points.

On top of that, both the largest and smallest corporate bond funds five years ago have beaten the sector average over the period.

Performance of composite portfolios vs sector over 5yrs

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Source: FE Analytics

The list of largest funds this time five years ago includes Invesco Perpetual Corporate Bond, which was £4.5bn then and is now £5.5bn; Pimco GIS Global Investment Grade Credit, which was £4.1bn then and is now £10bn; and M&G Corporate Bond, which was £3.8bn and has grown to £5.2bn.

Each of the 10 largest funds in the sector five years ago had an AUM of more than £1bn, while the average size of the 10 smallest funds at the time was just £23m.

Seven of the largest 10 funds five years ago have gone on to beat the sector since, while only half of the 10 smallest funds have managed to outperform.

The nimble portfolio’s average returns have been bumped by the likes of Rathbone Ethical Bond which has returned 64.72 per cent and F&C Corporate Bond fund which has returned 50.28 per cent.

Size hasn’t seemed to have had an impact over three years, either.

Our data shows an equally weighted portfolio of the 10 smallest corporate bond funds, as of August 2011, has returned 20.06 per cent over three years, while the largest funds have returned 20.38 per cent.

Again, both those portfolios have beaten the IMA Sterling Corporate Bond sector over that time.

While managers in the IMA Sterling Strategic Bond sector have a much greater flexibility and can invest in investment grade credit, high yield credit, sovereign debt and equities, FE data shows the largest funds in the sector five years ago have returned 53.7 per cent, beating their smaller rivals by more than six percentage points.


Performance of composite portfolios vs sector over 5yrs

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Source: FE Analytics

However, it must be noted that the list of the largest strategic bond funds five years ago includes funds such as Invesco Perpetual Monthly Income and Artemis High Income, which have maintained around a 20 per cent weighting to equities over the period.

Though the size of bond funds hasn’t seemed to have impacted their returns in the past, most investors who are avoiding the sector’s giants are doing so because of potential future liquidity concerns.

These worries intensified recently when the FCA warned investors that they may have difficulty selling their units in the sector’s largest funds if liquidity were to dry-up as a result of rising yields.

Therefore, in the study we compared how the largest and smallest funds have performed in the past when the bond market has been particularly illiquid.

One instance was during the financial crisis in 2008.

Clearly, the largest funds in the sector were much smaller six years ago than they are now – our data shows the average corporate bond fund was £555m and that figure now stands at £862m – but size once again didn’t seem to have an impact.

The largest fund in the sector lost 7.56 per cent that year, while the smallest funds fell 9.49 per cent. Both portfolios outperformed the sector average.

Another example was during last year’s taper tantrum, when former US Federal Reserve chairman Ben Bernanke warned the market that he was considering reducing quantitative easing – a form of money printing that had forced bond yields to very low levels.

The announcement, which was made in May, caused the prices of bonds to plummet.

Performance of composite portfolios vs sector in 2013


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Source: FE Analytics

According to FE Analytics, a portfolio of the 10 largest corporate bond funds in 2013 returned 0.41 per cent that year, while their smaller rivals lost 0.11 per cent.

Also, as the graph above shows, the portfolio of the 10 smallest funds fell further during that May/June sell-off.


These results seem to reiterate the points made by Paul Causer
(pictured), co-manager of the £5.6bn Invesco Perpetual Corporate Bond fund, who says the arguments used by many of the critics of giant bond funds are fatally flawed because all managers are operating in the same market.

“In my opinion, if everyone wants to take money out of the asset class, then everyone would be hit. If you’re trying to sell £20m or £2m you are going to the same market makers. It’s the price you get for the bond which is the issue, not whether you’re going to be able to sell it,” Causer said.

ALT_TAG However, the fatal flaw with this study, and others like it, is that it relies on past performance.

The large majority of experts who are concerned about giant bond funds say, because interest rates will rise from their ultra-low levels and the Fed will stop distorting the market, the next few years could be unprecedented for fixed income.

Data from RBS’ liquidity monitor shows liquidity in the credit markets, which they categorise as a “combination of market depth, trading volumes and transaction costs”, has declined by close to 70 per cent since the financial crisis.

The worrying aspect, according to RBS’ data, is that it is still falling.

Chris Metcalfe, investment director at IBOSS, told FE Trustnet earlier this month that he was avoiding all bond funds over £1bn for exactly that reason; fearing giant funds would be the worst hit in a liquidity driven sell-off.

“It is very difficult because we have never had this sort of environment and nobody really knows how big of an issue it is going to be. We just don’t want to be on the wrong side of it. It is one of those things that won’t come up on our fund screen as an identifiable risk,” he explained.

However, Mike Deverell – investment manager at Equilibrium – says investors would be wrong to just buy the smallest funds in the sector.

He agrees with Metcalfe that corporate bonds face a difficult few years, but he says investors should instead be focusing on the quality of their bond manager, not the amount of money they is running.

“I think people are getting the slightly wrong end of the stick when it comes to large versus small bond funds,” Deverell said.

He says that though smaller bond funds will have a better chance of outperforming than their larger rivals because they will be able to add more value on a stock-by-stock basis, while managers running a bigger pool of money will have to rely more on their macro calls, it is by no-means a given that they will top the sector.

He added: “I do think that smaller funds have the upper hand, but they are as equally at risk as large funds if liquidity were to dry-up.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.