by Dewi John.
I’ve cheated with the top-10 table this month. Normally, funds with less than a five-year track record are excluded. However, there are only 19 funds in the sector, only eight of which have five-year histories. As a result, not all those in the table have a Lipper Leaders score. Nevertheless, it’s a tale worth telling, so we will break our own self-enforced rules.
Investment 101 says that rising rates are bad for bonds. While that’s true in general, there are various little devils scampering round in the detail. One is that rising rates have already run a coach and horses through the market, blowing out yields. That’s bad news if you were invested in those bonds at the time, better news if you’re pondering dipping a toe into the asset class now (at least some of) the damage is done.
Bonds come with two main types of risk: duration and credit. The greater the duration, the more you’ll lose with any given rate rise; and the lower the credit rating, the greater the risk of default. If we are heading towards a global recession—and this is a growing consensus—then you want to be in higher-rated credit to shield from spiking default rates at the junkier end of the market. So higher-rated investment grade bonds (which we’re looking at here), rather than high yield, is likely to be the best pace in the fixed income market.
The $64m (and the rest) question, of course, is when the Bank of England and the Federal Reserve will stop raising rates, as this impacts on both risks.
The Fed is ahead of other central banks in the rate cycle, which has indicated to investors that this is an entry point into dollar-denominated debt. But if rates go higher than the market anticipates, then this could be the precursor to another leg down. Nevertheless, the market is less richly valued, with more attractive yields than at the start of the year, which has attracted money.
The currency makes a difference too. Over the year to the end of May, the Sterling Corporate Bond sector is down 8.5%, while its USD equivalent is up 3.7%. That said, there’s not much difference between the average yield between the two over the past 12 months, being 2.1% and 2.4%, respectively. And, of course, both denominations are lagging UK inflation.
This is a very passive- and exchange-traded fund-heavy sector: 17 out of the 19 incumbents are ETFs, and all of the 19 passively track a benchmark. That doesn’t, however, mean they’re all doing the same thing—far from it. Three-year returns range from 10.6% to 0.3%. Twelve-month returns range even wider: from 12.6% to -4.4%.
The top-performer over 12 months is the iShares $ Floating Rate Bond UCITS ETF. As the name suggests, the fund replicates an index of dollar-denominated bonds that track a reference rate, such as the Federal Funds Rate. As such, as that rate rises the coupon does in line with them. It’s not inevitable that such securities will outperform in a rising-rate market, as rising demand will likely increase the price paid for them, thus lowering the yield.
The top-performer over three years is the Xtrackers ESG USD Corporate Bond Short Duration UCITS ETF. This, along with three other ETFs in the table, track indices of short-term bonds. These invest in bonds with (generally) three years or less to maturity, and are less sensitive to rate increases, and so the value of their principal will fall less as rates rise.
However, if inflation and base rates stabilise, then conventional, longer-dated investment grade bonds will start to look more attractive. That’s not a given any time this year but when it occurs, we’ll likely see a shuffling of the deck in this sector.
Table 1: Top-Performing USD Corporate Bonds Funds Over Three Years (with a minimum five-year history)
All data as of May 31, 2022; Calculations in GBP
Source: Refinitiv Lipper
This article was originally published in July Moneyfacts, p19.
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