Diversified Income Fund

For resilient income, look beyond traditional corporate bonds

Many investors are moving back into bonds, especially traditional corporate bonds. But John Stopford warns that this may reflect overly optimistic views on the outlook facing companies today, and explains where he sees better risk-return opportunities.

6 Mar 2024

5 minutes

John Stopford
Ellie Clapton

John Stopford in conversation

In a short video Portfolio Manager John Stopford discusses his views on traditional corporate bonds and where he sees opportunities.

The fast view

  • At current spreads, traditional corporate bonds, in aggregate, are expensive.
  • There are opportunities for active, bottom-up investors within select parts of the corporate bond market.
  • The Ninety One Diversified Income Fund is asset class agnostic; in the current environment we are finding better income opportunities elsewhere1.

In the final quarter of 2023, a resilient US economy and cooling inflation fuelled an intense year-end bond rally, rescuing fixed income markets from an almost unheard-of third straight year of declines.

Global investment-grade bonds in major markets, including government and corporate debt, rallied by about 7%2 over November and December - its strongest two-month period over the last 30 years. US investment grade corporate debt posted an 8.5%3 total return during the final quarter of 2023, with an excess return of 2.0% over duration-matched US Treasuries.

In response to the favourable events and conditions during the quarter, sentiment for bonds, in particular corporate bonds, improved. As such, about US$14 billion in assets entered US investment-grade bond funds in 2023, totalling US$123 billion of net inflows in that year.

However, we believe that traditional corporate bonds, at least at a broad index level, are expensive in aggregate and that some investors are too sanguine about the months ahead. Spreads have tightened to near their lowest level in 18 months, diminishing the usual higher return associated with increased risk. The BBG US Corporate Investment Grade Bond Index option-adjusted spread (OAS) shrank by 22 basis points (bps) in Q4 2023 and 31bps on the year, ending at 99bps.

Figure 1: Corporate bonds look likely to underperform government bonds over the next few years

Figure 1: Corporate bonds look likely to underperform government bonds over the  next few years

Source: Ninety One, Bloomberg, 31 December 2023.

Figure 1, which uses almost 40 years of US data, suggests that at current yields Investment Grade corporate bonds have a greater than 50% chance of delivering a lower return over the next three years than the traditionally safer government alternative. The outlook for traditional High Yield corporate bonds is worse.

While spreads are tightening, other challenges to be aware of include the expanding fiscal deficit, the coming need to refinance low-rated corporate debt, and the market’s most significant assumptions: that growth will hold up and inflation will fall smoothly and orderly towards the Fed’s 2% target.

Figures 2 and 3 illustrate that investing in corporate bonds for their additional yield currently appears to offer materially worse odds on average than a simple coin toss when yield spreads are at their current tight levels.

Figure 2: How often High Yield underperforms government bonds over following three years at different starting spread levels (shown in basis points)

Figure 2: How often High Yield underperforms government bonds over following three years at different starting spread levels (shown in basis points)

Figure 3: How often Investment Grade underperforms government bonds over three years at different starting spread levels (shown in basis points)

Figure 3: How often Investment Grade underperforms government bonds over three years at different starting spread levels (shown in basis points)

Source: Figures 2 and 3: Ninety One, Bloomberg, 31 December 2023. The shaded bar represents spread as at end of 2023.

While Investment Grade and High Yield corporate bonds generally offer attractive risk adjusted returns, we believe that at this point in the cycle they could underperform equivalent maturity government bonds and at worst deliver significant, unexpected losses. This is likely to be a challenge for portfolios with large structural exposures, such as some strategic bond funds.

The Ninety One Diversified Income Fund (DIF) is asset class agnostic, focused solely on identifying those securities paying resilient and attractive yields from across the full spectrum of global investments. As such, we do not need to hold positions that appear unattractive and our positions in different asset classes have varied significantly through time to reflect our assessment of where to find the best resilient income opportunities. The portfolio’s historic exposure to credit is an example of this.

The exposure to investment grade and high yield corporate bonds reached an historic high of 33% in May 2020, as the sharp falls in the height of the pandemic saw prices dislocate from fundamentals, creating significant future return opportunities. However, as at today, the exposure has been taken to a historic low of 9%. We would look to increase this exposure as the risk reward on offer improves. DIF continues to be cautiously positioned in terms of both equity and credit risk, looking for opportunities to pick up attractively valued, resilient income-generating securities which offer compelling cash flows and potential returns.

Figure 4: DIF historic asset exposure

Figure 4: DIF historic asset exposure

Source: Ninety One, Bloomberg, 31 December 2023.

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1 Past performance does not predict future returns; losses may be made.
2 Bloomberg Global-Aggregate Total Return Index USD.
3 BBG US Corporate IG Bond Index.

General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.

Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Government securities exposure: The Fund may invest more than 35% of its assets in securities issued or guaranteed by a permitted sovereign entity, as defined in the definitions section of the Fund’s prospectus.

John Stopford
Portfolio Manager
Ellie Clapton
Portfolio Specialist

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

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