Corporate Bonds party is over
In January 2010 we were still in party mood, celebrating the marvellous returns from corporate bond funds in the prior 12 months, and we felt that there were still decent returns to be made (there were until May), that Gilts were a worry (that proved wrong), and that we shouldn’t be worried unless there was a renewed economic downturn or a shock similar to 2008. It is the latter two risks which have concerned us since May.
In the calendar year to end-April the top performing funds (such as Henderson Sterling Bond and Old Mutual Corporate Bond) had already exceeded our growth target for the whole year (10%).
The catalyst for the May volatility was growing concerns over the risk of default by Greece (whose bonds are widely held by European banks), and in particular liquidity began to dry up. This meant that it was difficult to either buy or sell individual bond issues, particularly bonds issued by banks which make up a large part of the whole corporate bond market.
You will recall that it was holdings of bank bonds that drove the performance of the most successful bond funds over the last 12 months or so, with the Henderson and Old Mutual funds up in excess of 60% from the March 2009 lows. Yet renewed liquidity concerns, a key component of sharp falls in 2008, highlighted that risks were rising. Where we had seen the potential for double digit returns and limited risk, the risk/reward balance completely changed from May 2010.
The other risk that began to emerge in May was signs of a renewed economic slowdown, particularly in the US, which remains the motor at the centre of the world economy. Now fears of deflation are growing.
gilts driving corporate bonds
The way that markets reacted to these emerging risks was instructive. The US dollar improved as a safe haven, as did US Treasuries (no one is worrying about US sovereign debt just yet). Gilts, bonds issued by the UK Government, also improved as, compared to many European countries, the UK also enjoyed safe haven status (which caught a lot of us off guard).
In the context of corporate bonds, the highest quality non-financial bonds also improved; you will recall that 80% of the movement in corporate bonds can be explained by Gilts, so if Gilts improve so will corporate bonds, particularly non-financials. This benefitted some of the more conservatively managed funds (e.g. Fidelity Moneybuilder Income and M&G Corporate Bond) and highlighted their capital preservation potential.
We should also acknowledge the resilience of the aforementioned Henderson and Old Mutual funds during May. Although some individual bank bonds fell 20%, these two funds were down less than 2%, barely a dent in the performance since March 2009. This is a credit to two outstanding fund managers who had been taking profits on bank bonds, and reducing risk, for some time.
With economic tsunamis now sweeping global financial markets with increased regularity, now is not a time to be brave. This is not us trying to time the markets, but rather applying a straightforward process, appropriate for the time:
- buy assets when they are obviously cheap,
- taking profits when they are obviously expensive, or
- when risks are obviously rising
As the Daily Telegraph quoted us as saying of ourselves a few years ago “if we’re experts in anything it’s the bleeding obvious”. In simple terms you need to do a mix of things:
- take some profits
- reduce risk
- add diversification
(Taken from TopFunds Guide July 2010)