Bond funds have been in the spotlight since the major central banks ended their rate hiking cycle last year, as investors and fund managers endeavoured to lock in historically high yields and position themselves to make capital gains when yields started to fall.
In light of renewed investor interest, as well as the volatility seen in bond markets during the past couple of years, Trustnet asked fund managers to highlight some of the risks involved with fixed income investing and to suggest ways to mitigate them.
Don’t get too greedy
Credit spreads are tight, which means that corporate bonds are not offering investors much compensation for taking additional credit risk, said Nicolas Trindade, who manages a range of short duration strategies for AXA Investment Managers.
On the other hand, sovereign bonds yields, particularly in the US, have repriced significantly higher this year in reaction to sticky inflation data. “Treasury yields are 50 basis points higher on a year-to-date basis and the market has gone from expecting six interest rate cuts from the US Federal Reserve at the end of 2023 to two. So, it is amazing to me that risk assets have barely reacted at all,” he said.
“Credit spreads tightened substantially at the end of last year because the market thought the Fed would cut a lot. Now no-one thinks the Fed will do that, but credit spreads haven’t really widened to reflect that significant change of view.”
Therefore, Trindade warned investors to remain cautious, given that inflation could still surprise to the upside.
“The risk – the thing that will finally break the market – is that the Fed opens the door to interest rate hikes. That is not our central scenario, but investors must have it at the back of their minds. Investors should not get greedy in an environment like this. Yields have come right back up after the sell-off, so you don’t need to take big risks to get a good return.”
Short-dated bonds are attractive from a yield perspective, he continued, and given that sovereign yield curves are inverted, there is little incentive to buy longer bonds.
“If inflation continues to surprise to the upside, particularly in the US, investors will get better protection from short-dated paper. Investment grade bonds at the front of the curve offer a nice combination of better yields, less duration and solid fundamentals.”
Credit investors can’t afford to ignore sovereign debt
Corporate bonds are priced off the government bond yield curve. Therefore, credit investors should check whether the equivalent government bonds of the appropriate currency and duration are correctly priced and reflect their view on interest rates, said Emma Moriarty, an investment manager at CG Asset Management.
By way of example, the duration of CG’s sterling corporate credit portfolio is two years, so Moriarty has been analysing two-year gilts, which are “probably fairly priced for our rate expectations so that’s a duration we’re comfortable to ride”.
She agreed with Trinidade that investors are getting less compensation for credit risk as spreads have tightened. CG has reduced its sterling corporate credit allocation over the past few months after making capital gains because there is “not much more room”.
Corporate bonds behave like equities in a crisis
In times of stress, corporate bonds – especially BBB-rated bonds – can become relatively illiquid and cease to provide diversification against equities, said Will McIntosh-Whyte, a fund manager in Rathbones’ multi-asset team.
“If you have lots of people running for the exits at the same time, these things can move to big discounts, particularly in a 2008-type scenario. They can then suddenly behave more like equities because they're not always the most liquid, and particularly when you get down into the BBB area. In really difficult markets, it can become quite difficult to sell them at all, unless you want to take a nasty haircut to the price,” he explained.
“I'm not saying you should never hold corporate bonds, but I think you just need to be wary of what they are.”
Rathbones’ multi-asset team classifies asset classes into three buckets: liquidity, equity-type risk and diversifiers. Corporate bonds belong in the equity risk bucket, while government bonds are in the liquidity bucket because “you can always sell them in any market at the market price”.
Government bonds are not necessarily low risk, however. “You don't really have that credit risk, but you can have volatility because you've got that interest rate risk and obviously, we saw that in spades in 2022.”
This is why Rathbones has a third bucket of uncorrelated return streams, such as a US rates volatility trend note and S&P 500 put options.
Avoid fallen angels
Corporate bond prices plummet when the company that issued them is downgraded, especially if it falls off the cliff from investment grade to high yield, said Adam Whiteley, head of global credit at Insight Investment.
Insight Investment uses a ‘landmine checklist’ to spot which issuers might get downgraded ahead of time. Companies that are taken private or that undergo management buyouts with an element of private equity funding raise a red flag because transactions are often financed with debt, he said. This can lead to ratings downgrades due to higher levels of debt on the company’s balance sheet.
The firm’s landmine checklist looks out for characteristics that might attract private equity acquirers, such as: a share price that is underperforming versus the peer group; a modest size so the whole entity can be acquired; and stable earnings and cash flow to pay off the debt used to finance an acquisition.
The next step involves digging into the bond documentation. Some bonds have a clause where they must be redeemed at par if the issuing company’s ownership changes hands. When corporate bonds are trading below par, a change of control can deliver some upside, he explained.