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August 29, 2023

In for the Duration

by Dewi John.

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

 

Bonds, as we’ve been repeatedly told this year, are back. But are they worth backing?

Bonds have been the asset class of choice for the year. UK investors have put £10.3bn into bond funds in the first six months of 2023. In contrast, equity funds have suffered £8.3bn of redemptions.

While the value of bond principals has been hit hard as base rates have risen, this same process has, by definition, increased yields in outstanding bonds and forced new issuers to offer higher rates. With inflation elevated, the value of current cash flows (in other words, yields and dividends) increases relative to the value of future ones. So, value trumps growth in the equity world—although the outperformance of growth this year is an interesting conundrum, and one to which we can perhaps return.

In a world wary of recession, as pundits move from despair to euphoria and back again with every US non-farm payrolls or purchasing managers’ survey announcement, bonds have an additional appeal, as the higher the quality the greater their defensive value in a recession—certainly relative to equities.

The sweet spot is to get in at the point that the inflationary wrecking ball has slowed to give your portfolio no more than a nuzzle, rather than crash right through it: where yields are elevated and bond principals present good value. Looking at the current trajectory of inflation, that might be about now—with a very strong emphasis on might, as there are any number of factors at play. But it’s a credible case. And, in any case, fixed income is a core component of a balanced portfolio.

So, it is worth having a look at the Sterling Corporate Bond sector. It’s the second largest Investment Association bond sector after Sterling Strategic Bond and two-thirds of the size by assets.

At first pass, historic returns don’t make the heart race: an average of -5.4% over 12 months to the end of June. The -15.5% three-year returns may make your heart race, albeit for the wrong reason. Even the negative figures over three months through the table below—and with an average three-month loss of 3% for the sector as a whole—indicate that duration, the effect of a change in interest rates on the value of a bond—is still having a negative effect.

Yields, too, at an average 3.5%[1], look unexciting, especially when compared to the current level of inflation. But events over the past couple of years have pushed them in the right direction, as the equivalent figure three years ago was 2.3%.

The most noteworthy thing about the table below is that all the funds except one—the IFSL Church House Inv Grade Fixed Interest fund—are short duration. That means that they were all relatively insulated against the rapid rise of rates we’ve seen over the past year or so. For instance, the average fall over three years is 4.1%, as opposed to the 15.5% cited above. This is why those ‘past performance is no guide to the future’ notices never cease being relevant as, when rates stop rising these funds will lose their edge. We are likely near that point.

Certainly, the top 10 will have looked very different to this a year or two ago. The longer the duration of a fund, the more sensitive it is to changes in rates. So, if rates go up at all, the funds in this table should all do relatively well. However, the converse is true: that if rates begin to fall, then funds with longer durations should—all things being equal—appreciate more than shorter duration funds.

Second guessing the trajectory of inflation, and how the Bank of England’s Monetary Policy Committee will react to that, is a mug’s game, so I’m going to resist being drawn in. But these are factors you need to consider when poking a stick at the opaque world of bonds.

 

 

Table 1: Top-Performing Sterling Corporate Bond Funds Over Three Years (with a minimum five-year history)

All data as of June 30, 2023; Calculations in GBP

Source: LSEG Lipper

 

[1] Annualised distribution yield over 12 months.

 

This article appeared in the August edition of Moneyfacts, p13.

 

LSEG Lipper delivers data on more than 360,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of LSEG Lipper. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. LSEG Lipper 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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