November 9, 2021

Inflation: The Spectre Haunting Bond Funds

by Dewi John.

Using the Lipper Leaders scoring system to analyse the best-performing funds in the IA Sterling Corporate Bond sector.

 

The Sterling Corporate Bond sector saw the fourth largest inflows over the year to the end of September—the largest flows of any non-equity sector. It’s long been a portfolio staple for investors looking for relatively low-risk reliable income.

However, with inflation on the rise, bond funds are vulnerable to losses. Large increases in energy prices have generated fears that the current upward inflationary trend is more than a blip caused by a post-COVID mean reversion (if that is indeed what we are experiencing).

In mid-October, Bank of England Governor Andrew Bailey said that the bank “will have to act” by raising rates to keep inflation tamed. If rates go up, fixed income investors will feel pain. The longer the duration of their portfolios, the more pain they will feel.

Before the Bank’s September meeting, only one increase from the current historic low of 0.1% was anticipated by summer 2022. The Financial Times now reports that an “increase to 0.25 per cent by December is viewed as a coin toss by futures markets”.

Two- and five-year bonds tend to be the most sensitive to inflation, and the yield on two-year gilts is now the highest since before the pandemic.

 

Uphill Struggle

Sterling corporate bond funds have already reacted, with the sector down 1.8% over September. Only one fund is up over the month—BNY Mellon Global Credit, which looks somewhat out of place in the sector—with one fund falling by 5.5%. While that’s not in our top 10 over three years, the second-placed BMO Long Dated Sterling Corporate Bond fell 5% in September.

Even without the effects of rising inflation, corporate bonds are struggling to deliver returns above inflation. If we take an index-tracking sterling corporate bond ETF as a proxy for the broad market, you can see the issue. The Vanguard UK Investment Grade Bond Index GBP Acc has returned 0.13% over 12 months to the end of September. While active managers have the capacity to beat that, the sector return for the same period was just 0.93%. With the September consumer price index coming in at 2.9% and the Bank of England’s expectation of 4% inflation by the end of the year, investors face a growing problem.

The other issue to be wary of is credit risk. The lower the credit grade, in general the greater the yield will be, as investors are rewarded for the greater risk. Investment grade credit, which is supposed to form a minimum of 80% of the portfolios in this sector, should be a safer bet than high yield (otherwise known as “junk bonds”, of which these funds are permitted to hold up to 20%). Investors in this sector therefore need to be mindful of just how much of their return is being driven by non-investment grade bonds, and the risks this entails.

The top fund in the sector over both one and three years is the Schroder Sterling Corporate Bond C Acc GBP. It’s September 2021 fact sheet reports 71.6% in investment grade credit, which is a considerable margin below that 80% floor. Its return is more than four percentage points over the second-placed Royal London Sterling Credit fund over 12 months (which Lipper data shows is also running below the 80% sector limit, though by a smaller margin). This poses the questions of just how much of that return has been achieved by non-investment grade holdings? If the managers bring the portfolio back within the sector guidelines, is the performance sustainable, and if not, are you comfortable with the additional risk?

The top-performing managers have demonstrated considerable ability in delivering the returns they have, but there’s likely considerable turbulence ahead.

 

 

All data as of September 30, 2021; Calculations in GBP

Source: Refinitiv Lipper

 

This article was originally published in Moneyfacts, page 16.

 

Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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