Corporate bonds across the entire credit quality spectrum have produced exceptionally strong returns in the post-financial crisis period. Long-term investors have reaped the rewards of this while shorter-term investors have, arguably, tried to be cute with their exposure and in doing so have delivered sub-optimal performance in lower risk portfolios.
2018 has been full of 10-year anniversaries in the investment industry, all of various notorieties. Next month marks the 10-year anniversary of the commencement of quantitative easing, or QE as its more commonly known, by the US Federal Reserve. We now know that QE has had a significant effect on the yield of government bonds and, in turn, the spread on corporate bonds. The bond market has always been the more complex sibling of the equity market but actions taken by the Fed at the height of the panic in 2008 shone a new light on the asset class.
For long-term investors with their imbedded strategic asset allocations, their diversified exposure to both government and corporate bonds have paid off handsomely. Indeed, their exposure to equities has also paid off, albeit with a lag. By September 2012 the Fed had engaged in QE3, their third and final round of quantitative easing. Bond yields continued to compress through the various iterations of QE but by 2013 investors began speculating on how low yields could fall or at least remain as low as they were.
For short-term investors, with more loosely defined strategic asset allocations, questions around yield mean reversion became commonplace. If yields could fall this low, it was intuitive enough to assume that they could rise as high, ushering in a return to more normal economic conditions. Whilst events in Europe in the summer of 2012 illustrated how far away from normal some developed economies were, for the short-term investor the concern was now focused around capital losses for bonds when (not if) bond yields rose again.
This led to a proliferation in shorter-duration strategies focused principally around corporate bonds, both investment grade and high yield. These strategies were not new but for the short-term investor they warranted new attention for their “capital protection-like” properties. The rebirth of the short duration corporate bond fund was driven by a belief that they could protect your portfolio from rising bond yields. The longer yields remained low, the greater the expectation of a material spike back higher – it was assumed that no portfolio could possibly survive that scenario.
Fast forward six years from the summer of 2012 and the performance of short-dated investment grade corporate bonds versus their traditional, all-maturities counterparts is significantly weaker. Naturally some of this should be expected, shorter maturity bonds typically have a lower yield premium which impacts the return profile. Today the yields across nearly all government bonds are materially higher than they were in 2012 yet this doesn’t appear to have driven negative performance across all-maturity corporate bond funds (so called because they invest across the entire yield).
There are two fundamental reasons for why this has occurred. Firstly, the effect of roll down is quite powerful in credit. This is the annual return that is generated in addition to the credit spread as a bond moves down in maturity (or ‘rolls down the curve’), e.g. from a six-year bond to a five-year bond. The shorter the duration of your corporate bond fund, the smaller the roll down gains are. Secondly when central banks raise interest rates it causes the shorter end of the yield curve to rise, where there is more sensitivity to base rates. In this rate rising environment the move up in the yield curve has not been parallel across the curve, which has been to the detriment of bond prices in the shorter duration space.
In hindsight it is easy to criticise the short-term investor base but it does illustrate the value in managing a diversified fixed income portfolio for clients. Going forward, with government bond yields seemingly on a precipice and the credit cycle looking increasingly long in the tooth how can investors be defensive in corporate bonds?
Being diversified will help, across credit ratings, across regions and across maturities. Being nimble will always help, finding relative value and having the conviction to allocate away from strong performers into weaker parts of the credit market. In addition to all the sensible portfolio management tools at an investor’s disposal, we believe there is also an opportunity to find exposure to more downside-focused actively-managed funds. The universe of these types of strategies are certainly smaller in size and can be quite niche in appearance however they can improve the risk-adjusted return profile of an investor’s corporate bond allocation and, consequently, the wider fixed income portfolio.
Two names that we like in this space are the Hermes Multi-Asset Credit fund and the TwentyFour Absolute Return Credit fund. Hermes have a portfolio construction process where one-third of the portfolio is treated as a defensive bucket while TwentyFour have sought an investment approach which seeks to target credit rating profiles with the strongest Sharpe ratio. Both funds complement a more traditional long-only approach that will always remain the mainstay.
Jordan Sriharan is head of fund research at Thomas Miller Investment. All views are his own and should not be taken as investment advice.