Average funds posting losses of -14.34% over three years as peer group demand drives spreads to unattractive levels
The reputation of corporate bond funds as a relative safe haven from the volatility of the stock market has taken a beating over the past three years.
The ravages of the credit crunch have seen millions of pounds wiped off the value of UK fixed income funds.
In the Investment Management Association's £ Corporate Bond sector, only eight of the 81 funds have delivered positive returns over the three years to 20 February and not one proved able to keep pace with cash.
The average fund posted a loss of -14.34%, according to Morningstar data, but the disparity of returns has been marked with the best-performing fund, M&G Strategic Bond, outperforming the worst, New Star Sterling Bond, by 47.1%.
The sector actually posted falls in each of the last three years but the bulk of the damage, in absolute terms, was done over the last 12 months when the average fund returned -9.8%.
The seeds, however, had really been sown towards the end of 2006 and the early part of 2007 when the combination of a period of historically low interest rates, government bond yields and default rates led to strong demand for corporate bonds, which drove spreads down to unattractive levels.
This lack of risk premium for holding corporates led many managers, such as New Star Sterling Bond fund manager Phil Roantree, to adopt a defensive stance as spreads narrowed to as low as 68 basis points over 10-year gilts.
However, as the credit crunch started to take hold over the summer, many fund managers began to unwind their defensive positions and move down the credit spectrum, lured by the prospect of picking up extra yield.
Roantree, along with many other managers, moved into tier one bank debt, the most junior bonds issued by banks, as spreads rapidly moved to historically wide levels.
"The spread widening, however, was not a short-term adjustment as we had seen in earlier years, but the result of a turnaround in sentiment towards credit as investors experienced losses from US sub-prime mortgage-related assets following the weakening US housing market," he says.
Similarly, Chris Bowie, manager of the Ignis Corporate Bond fund, says the fund, which was then run by a different manager, also moved overweight lower-rated paper from Royal Bank of Scotland and HBOS.
"We had too much money in banks and their lower-rated bonds but we thought we had taken on a degree of risk but not a stupid amount. We had no Icelandic or emerging market banks, for example, and no exposure to CDOs or SIVs," he says.
The weakness in the asset backed securities market heralded the start of a series of major write-downs for the investment banks, which in turn increased credit concerns, sucking liquidity out of the market as banks became fearful of lending, heaping further pressure on bank bond spreads.
"As many of the buyers of ABS and bank bonds in recent years were leveraged funds, wider corporate bond spreads forced them to reduce leverage and sell bonds, thereby putting further downward pressure on prices causing spread widening to become self-fulfilling," Roantree adds.
After the bailout of Northern Rock in February 2008 and Bear Stearns the following month, Bowie says that Ignis, along with many other fund groups "gave the US and UK governments too much credibility".
The lack of liquidity remained a major issue throughout 2008 and later in the year when both Bradford & Bingley and Lehman Brothers were surprisingly allowed to fail, the cost of trading out of lower tier bank paper became prohibitive effectively freezing holders into the deepening downward spiral.
"We thought the governments would bail out Bear Stearns and B&B but there was no consistency to their approach. After B&B, RBS and HBOS, bonds became almost impossible to trade because with the price you would get, you would be better off holding onto it, even if it defaulted," Bowie says.
Paul Read, co-manager of the Invesco Perpetual Corporate Bond fund, also points to the August failure of Lehman as a landmark event.
"We had been adding more risk throughout last year but since the collapse of Lehman we have seen almost every holding marked down and sometimes very aggressively," he says.
He draws parallels between how he approached the telcos in 2000, to how he has selectively picked up bank debt and notes he has been favouring the recent government-backed issuance.
Read's fund, which he runs alongside Paul Causer, fared better than most in the 12 months to 23 February 2009, falling by -7.09% compared to a sector average fall of -9.8%.
The Ignis and New Star funds were among the worst hit, however, down -27.37% and -35.9% respectively, according to Morningstar.
Technical factors also hit performance of the Ignis fund and several peers over the past year, such as Stephen Snowden's Old Mutual Corporate Bond fund.
Both said the index prices quoted were so far from the reality of certain bonds worth, many of which had not been traded for several months, that they started pricing their own holdings internally on a daily basis.
Bowie believes this has added a further 4.5% of underperformance to the fund's one year figures but has been key to ensure both exiting unitholders and new entrants are treated fairly.
Snowden finally took the hit and exited his RBS subordinated debt after the bank's negative December trading statement.
"The fund declined by 8.1% in January 2009 as the main negative contribution came from our holding in subordinated bonds issued by RBS, which was subsequently sold," he says.
While the fallout from the banking crisis may have wrecked many funds' track records and even a few reputations, a few winners have emerged from the crunch.
Andrew Sutherland, manager of the Standard Life Investments AAA Income fund, says his fund was able to avoid the pitfalls of the past 12 months through its lack of exposure to lower tier paper and focus on the highest quality corporate issuance and government paper.
His portfolio returned 3.41% over the discrete period ranking it sixth out of 91 in the peer group.
"Our process has not changed and we did not really have any individual stock stories over the last 12 months," he says.
"The main positive feature, particularly in the second quarter, was our 10% holding in UK index-linked gilts.
"At the time, people were worrying about rampant inflation and the sector responded very well to the downward movement in commodity prices and it proved very positive selling out of the holdings in June and July."
In the fourth quarter, the fund also benefited from being slightly long duration as the Bank of England cut base rate to 2%, narrowing the spreads on more interest rate sensitive high quality corporate bonds.
January proved another tough month for the sector as it slid a further -3.7% on average. However, many managers are optimistic that valuations on a medium-term view offer compelling value.
Bowie says: "Corporate bonds are at their cheapest levels in their lifetime as an asset class."
Sutherland agrees, noting that the outlook remains "very good over the medium-term."
With such consensus, it is hard not to agree that value is emerging in the sector but the recent performance figures are not likely to tempt many investors in the coming Isa season.
