Sterling corporate bonds fell heavily out of favour in 2013 as investors left the sector in their droves. What happened? And what will happen next? Laura Miller finds out.
In 2013, fixed income funds – which were the best-selling in 2012 – saw their first ever net retail outflow.
According to figures from the Investment Management Association (IMA), the worst-selling sector for the year was sterling corporate bonds, with an outflow of £1.7bn.
This was the lowest net retail sales ever recorded for the sector since it launched in 2008. The sector was the worst seller for seven months during 2013.
While the UK economy is growing, the risk of default is probably an okay one to take
So what happened to make investors turn their back on sterling corporate bond funds? According to Aberdeen Asset Management senior investment manager Scott Spencer, part of the answer is investors reflecting on a three-decade wave.
"The outflows from the sterling bond sector are not surprising given the 30-year bull run the fixed income market has enjoyed," he said.
Architas multi-manager Caspar Rock goes into more detail: "What happened to the sector last year is that people got worried about interest rate duration exposure in their portfolios."
He added: "If you have a long duration asset and interest rates go up you will lose a lot of money. UK corporate bonds have about eight years' duration, and there has been a lot of concern about an interest rate rise.
"In that environment, people have been saying ‘hold shorter-dated funds'. Investors have been switching into bond funds that are designed to think more about interest rate sensitivity, like strategic bond funds."
As well as the risk of rising interest rates – still at a record low of 0.5% – Bestinvest senior research analyst Ben Seager-Scott also blamed the restrictive nature of UK corporate bonds.
"They’re fairly inflexible in what sort of bonds can be held," he said. Seager-Scott believes the negative sentiment about the sector that pervaded 2013 will continue this year.
It is also a view held by Charles Stanley head of investment research Ben Yearsley, who believes there are better bond opportunities out there.
"I will be amazed if this year is better for sterling corporate bonds with the prospect of a rate rise on the horizon. The problem last year and now is that, with an improving economy, high yield offers much better prospects than investment grade," he said.
Spencer notes the strategic bond, high yield and global bond sectors all experienced inflows last year as investors looked to diversify their fixed income exposure.
He said Aberdeen's Multi-Manager Cautious Managed fund has no exposure to traditional sterling corporate bond funds. Instead, it invests in more flexible strategies that allow managers to take advantage of opportunities across the credit spectrum and in multiple geographies.
Rock – whose funds do have exposure to sterling corporate bonds – is more measured about the outlook for the sector.
"It wouldn't surprise me if more money moved out of it as people search for lower duration, but sterling corporate bonds should form part of a diversified portfolio," he said.
"The sector is not a bad place to be. With corporate bonds you are paid an extra spread for holding some credit risk; you're being paid for the risk of that company defaulting.
"While the UK economy is growing, the risk of default is probably an okay one to take. Credit spreads are reasonably attractive in the UK. And corporate bonds are still safer than equities because, in the event of a failure, bondholders are paid out before shareholders."
Ones to watch
Rock likes the Invesco Perpetual Corporate Bond fund – which is in the top quartile over one year and second quartile over two years – as it did well in 2013 due to a reasonable weighting to financial corporate bonds and shrewd duration plays.
He also holds the Axa IM Sterling Corporate Bond fund, Kames Investment Grade Bond fund, and the M&G Inflation-Linked Corporate Bond fund, which has exposure to index-linked gilts of quite short duration.
Aviva Investors head of multi-asset retail Peter Fitzgerald prefers exposure to global corporate bonds rather than just sterling corporate bonds, given the greater diversification and lower interest rate risk.
However, he believes the returns for corporate bonds in general will disappoint this year.
"This may come as a surprise for retail investors," he said, "many of whom have become accustomed to equity-like returns from their bond investments. As these returns fail to materialise, there is a risk that investors [will] continue to sell."
So, according to many multi-managers, the near future at least doesn't look that bright for the sterling corporate bond sector.
However, Rock's view that holding some exposure to the sector as part of a diversified portfolio should not be discounted – fixed income will still play an important role in providing a regular income stream.
Chapters Financial founder Keith Churchouse
"Sterling corporate bond funds are looking a lot more favourable, but may take more than 2014 to recover."
Corporate bond fund manager view
Ignis corporate bond fund manager Chris Bowie
"We have a large overweight to UK issuers and have had for some time. We are positive on the relative strength of the UK economy, which continues to post resilient economic numbers. We have a 63% allocation to the UK, which is 10% higher than the benchmark.
"Within the UK, we have a strong exposure to UK tobacco companies – which are global franchises delivering solid earnings. We are less constructive on the high street names, which find it notoriously difficult to deliver consistent margins.
"Certain names in the sector, the likes of Marks & Spencer, also continue to be in the eye of private equity or leveraged buyouts – which could substantially undermine credit investors."
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