When selecting a sterling corporate bond fund, many of the usual considerations apply. These are well summarised within the conventional ‘five Ps’ of fund research: People, the calibre of the fund manager/managers and wider team; Philosophy, what inefficiency do the team believe they can exploit within markets; Process, how do they exploit this identified inefficiency; Performance, how successful have they been in this strategy over time; and Price, is the fund available at a reasonable fee?
However, when selecting a sterling corporate bond fund there are a number of additional areas relating to a fund’s risk profile that deserve close attention too.
These are particularly pertinent given the more defensive role corporate bond funds typically play within multi-asset portfolios.
Duration risk
Firstly, investors should consider a fund’s duration risk, which is its price sensitivity to changes in interest rates. Duration is generally seen as a positive feature of an investment-grade corporate bond fund, as it protects the fund in typical risk-off environments, where central banks lower interest rates to stimulate growth.
Most funds in the sterling corporate bond sector are managed within two years of the duration of their index. However, some funds have wider parameters, which can significantly change their risk profile.
Credit risk
Secondly, investors should carefully consider a fund’s credit risk, which is the level of exposure a fund has to movements in credit spreads – the additional yield investors receive for lending to companies rather than governments.
However, unlike duration risk, there are multiple ways to assess credit risk within corporate bond funds, with no one approach exhaustive. Below we list some of the indicators we consider, ranked from simplest to most complex:
Yield: Nothing comes for free in life, so a higher yield means more credit risk in a fund.
BBB exposure: A BBB rating is the lowest rung of the ‘investment grade’ credit rating ladder. The more BBB bonds in a fund, the greater a fund’s credit risk.
Financials exposure: Often the highest yielding sub-sector in the investment grade market, these bonds therefore come with commensurately higher volatility.
High yield: Off-index exposure to a lower-rated and more volatile asset class (max 20% allowable).
Secured bonds: Bonds backed by specific assets (collateral) of the issuer. If the bond defaults, bondholders have a legal claim on these assets. Often these bonds are issued by more levered (indebted) companies, so can carry additional credit risk.
Hybrid bonds: Debt with deferrable coupons that pay higher yields due to their additional cashflow (and credit) risk.
Unrated bonds: Off-index exposure to bonds that have not been assessed by a credit rating agency. These bonds are typically less liquid and more volatile (max 20% allowable).
Spread duration: Measures the impact of a change in a fund’s credit spread on the fund’s price. The higher the spread duration, the greater the expected volatility of a fund’s returns.
Duration Times Spread (DTS): Measures the magnitude of credit spread risk in a fund. Calculated by multiplying spread duration (i.e. spread sensitivity) by how risky the portfolio is (i.e. spread).
Selecting a fund
As ever, there is no right answer to which fund to choose, as each sterling corporate bond fund offers investors a different risk/ return profile depending on the calibre of its philosophy, team and process, as well as its risk exposures.
As a general rule of thumb, a fund with more credit risk and less duration risk is typically more appropriate for investors seeking higher potential returns and who are comfortable with more volatility along the way.
A fund with less credit risk, and more interest rate risk, suits a more cautious investor.
Funds to consider
TwentyFour Corporate Bond: We like this risk-aware sterling corporate bond fund, managed by Chris Bowie and the team at specialist fixed income boutique TwentyFour Asset Management. The fund’s managers target superior risk-adjusted returns versus peers by allocating to bonds they deem to have the most attractive combination of yield and volatility.
Artemis Corporate Bond: Well-known bond investor Stephen Snowden and his team have done a great job since the fund's 2019 launch, consistently delivering outperformance for investors from both a sector allocation and security selection perspective. The managers look for idiosyncratic bond opportunities they believe are mispriced and are typically overweight BBB bonds.
Rathbone Ethical Bond: This fund usually takes on more credit risk compared to others in its sector, with a long-held overweight financials (75-80%, versus just circa 35% for a typical index). When it comes to sustainability, the team exclude a number of industries as well as seeking out companies with well-developed practices and policies in managing environmental and social factors.
Invesco GBP Corporate Bond UCITS ETF: This fund provides indexed sterling corporate bond exposure, delivering good tracking efficiency versus the Bloomberg Sterling Liquid Corporate Bond Index through time thanks to the fund’s operational efficiency and effective index replication.
Paul Angell is head of investment research at AJ Bell. The views expressed above should not be taken as investment advice.