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January 20, 2023

The Return of Longer-Dated Investment Grade Debt Funds

by Jack Fischer.

Fund flows and fund performance have a very close relationship. Oftentimes inflows trail good performance and outflows poor performance. Sometimes the headwinds are so strong and signals so clear that they happen together. 2022 was the worst year on record for taxable fixed income funds, and longer-dated investment grade corporate debt bore the brunt of it.

Lipper’s Core Bond Funds classification (-13.51%) suffered its worst year on record while only being able to attract a net $5.3 billion over the course of the year. The classification’s 2022 net inflow was aided by a strong November (+$11.2 billion) and December (+$11.1 billion). Through the first half of 2022, Core Bond Funds reported $27.4 billion in outflows. Outflows and poor performance were caused by a deteriorating economic outlook brought on by persistent inflation and seven interest rate hikes.

Have we reached the bottom?

Performance was strong in the fourth quarter of 2022. Core Bond Funds gained 1.74%, on average, to end the year. The classification has observed inflows in three straight weeks and 11 of the last 13. Last week, Core Bond Funds (+$2.3 billion) celebrated their largest weekly inflow since mid-March 2021.

Even with many market participants forecasting a recession in the coming year, economists are starting to tame their expectations of future rate hikes. If the economy receives no more surprises from employment, consumer price index, and producer price index reports, we will continue to see a shift in fixed income investor preference back toward a longer investment horizon. With duration risk, for now, seemingly lowered at the long end, the primary concern becomes credit risk. That’s where investment grade debt comes in.

Investors wanting higher yields can find it in shorter-dated issues. As you can see above, the 10-year/three-month Treasury yield spread has been around its lowest all-time levels. Market participants moving out on the curve are funneling capital into funds where default risk is lower. Core Bond Funds have already attracted $4.0 billion in inflows since the start of the year. That ranks the classification second only behind Lipper Corporate Debt BBB-Rated Funds (+$4.2 billion).

It is still early but signs are looking up for corporate debt funds.

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