Let's discuss... corporate bonds

masonic

Linton said:

Dead_keen said:

Linton said:

Dead_keen said:

Linton s

I am somewhat bemused by the concept of “older staler” bonds. Can you explain? Surely a bond continues paying the specified interest unless the issuer goes bust at which point the bond becomes valueless.

Have a look at this from April 2025: https://www.ft.com/content/ef86ccae-bcbf-4975-bb23-d1a39b7523df

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Thanks - the article is talking about trading corporate bonds, which seems to be easier in the US than the UK, and that some of those bonds are rarely traded and so don't change in price.  Therefore they are of no interest to traders. However they would still be generating the same interest they always did. Trading corporate bonds for profit is a very different scenario than using corporate bonds for income.  

A fund that is suffering net outflows would need to redeem holdings in order to repay exiting investors. You do tend to see that liquidity filters get applied to bond indexes, and active managers are probably wary of loading up on illiquid bonds.

DavidT67

Platforms such as WiseAlpha do exist which allow retail investors access to corporate bonds and offer fractional interests.  

Dead_keen

masonic said:

Linton said:

Dead_keen said:

Linton said:

Dead_keen said:

Linton s

I am somewhat bemused by the concept of “older staler” bonds. Can you explain? Surely a bond continues paying the specified interest unless the issuer goes bust at which point the bond becomes valueless.

Have a look at this from April 2025: https://www.ft.com/content/ef86ccae-bcbf-4975-bb23-d1a39b7523df

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Thanks - the article is talking about trading corporate bonds, which seems to be easier in the US than the UK, and that some of those bonds are rarely traded and so don't change in price.  Therefore they are of no interest to traders. However they would still be generating the same interest they always did. Trading corporate bonds for profit is a very different scenario than using corporate bonds for income.  

A fund that is suffering net outflows would need to redeem holdings in order to repay exiting investors. 

Exactly.  An open-ended corporate bond fund may find that lots of investors want cash and so effectively be a forced seller of things that are pretty illiquid / have large spreads.  

masonic

Dead_keen said:

masonic said:

Linton said:

Dead_keen said:

Linton said:

Dead_keen said:

Linton s

I am somewhat bemused by the concept of “older staler” bonds. Can you explain? Surely a bond continues paying the specified interest unless the issuer goes bust at which point the bond becomes valueless.

Have a look at this from April 2025: https://www.ft.com/content/ef86ccae-bcbf-4975-bb23-d1a39b7523df

Paywall                                    

You just need to register. It is free.

Thanks - the article is talking about trading corporate bonds, which seems to be easier in the US than the UK, and that some of those bonds are rarely traded and so don't change in price.  Therefore they are of no interest to traders. However they would still be generating the same interest they always did. Trading corporate bonds for profit is a very different scenario than using corporate bonds for income.  

A fund that is suffering net outflows would need to redeem holdings in order to repay exiting investors. 

Exactly.  An open-ended corporate bond fund may find that lots of investors want cash and so effectively be a forced seller of things that are pretty illiquid / have large spreads.  

Which affects those wishing to sell as they redeem at a depressed unit price or find the fund is gated. I've not heard of significant bond funds getting into liquidity issues (unlike property or a certain infamous "equity income" fund), but a depressed unit price provides a good entry point to a new investor, and is irrelevant to the long term investor. There are a few funds in the Investment Trust universe that are better suited to the illiquid side of the bond market. The fixed pool of capital avoids the vehicle being a forced seller and punishes those running for the hills and rewards contrarians through a large discount to NAV.

aroominyork

I'm re-opening this thread to challenge the point of buying corporate bonds only for income and not for capital gain. Linton wrote:

Corporate bond funds make most sense if one wants long term income using minimum capital. Once bought the capital value becomes irrelevant since there is no intention to sell. In theory a fund could steadily lose value and disappear over time but this does not seem to happen in practise with funds retaining a fairly constant long term value over decades.

I wrote in my opening post that "Trustnet shows 95 Sterling corporate bonds and, over the last three years, the index funds (HSBC, iShares, Vanguard) are in positions 70-75". Why is it that most actively managed bond funds outperform the index. Is it because companies that issue more debt to pay their bills - rather than those using debt as part of a solid growth plan - take up a larger part of a debt weighted index and so more of the top issuers/index constituents are failing companies? That makes an index fund an unattractive proposition.

Jonathan Golan of Man Group says he looks for bonds which are underpriced and sells a bond when it reaches fair value. I'm sure he is not the only one.

I buy nominal gilts for income with no expectation of selling for capital gain. But I definitely buy actively managed corporate bond funds for the potential of capital gains.

masonic

https://forums.moneysavingexpert.com/discussion/comment/82034980#Comment_82034980

So are you interested in income, capital gains, or total return? 😉 There are elements of all three in your post.

The first statement was about most actively managed bond funds outperforming the index and why that is. This performance is dependent on total return. The answer will undoubtedly be that bond returns are much more predictable than equity returns. The active manager simply needs to select and overweight the bonds with the highest YTM while avoiding increasing their fund's default rate relative to the index.

It is also possible to beat the yield of the index by biasing to higher yield bonds, while avoiding disproportionate capital losses, although that's a bit easier to do in the sphere of equities (cf. equity income funds), so not as impressive.

Then there is bond trading for capital gains, which is also made easier by the limited duration of a bond vs a company share - unless a bond actually defaults, the gain will come within a finite period of time, unlike a share which could limp along, undervalued, for decades. From memory, taking the example of Jonathan Golan, his funds tended to be fairly short in duration, which means if the market doesn't revalue a bond quickly, he can rely on pull-to-par without too much of a drag on his strategy.

That said, achieving more than double the return of your peers suggests some very good calls are being made on valuation.

aroominyork

So are you interested in income, capital gains, or total return? 😉 There are elements of all three in your post.

All three, please! It’s surely difficult to get much capital gain outside higher yielding bonds. An AA-rated 4% corporate bond is unlikely to have many nice surprises under the hood to make it appreciate.

It is also possible to beat the yield of the index by biasing to higher yield bonds, while avoiding disproportionate capital losses…

If it is straightforward to get higher yield without default risk, doesn’t that suggest it’s an easy game to play?

Then there is bond trading for capital gains, which is also made easier by the limited duration of a bond vs a company share - unless a bond actually defaults, the gain will come within a finite period of time, unlike a share which could limp along, undervalued, for decades. From memory, taking the example of Jonathan Golan, his funds tended to be fairly short in duration, which means if the market doesn't revalue a bond quickly, he can rely on pull-to-par without too much of a drag on his strategy.

He generally holds short-medium in his BBB/junk funds, though he also has IG-titled funds to attract more conventional money. But surely pull-to-par will provide minimal gain unless he has found a bargain; a ‘correctly’ priced bond will trade at par throughout its life, simply returning the coupon Linton is asking for.

masonic

https://forums.moneysavingexpert.com/discussion/comment/82035052#Comment_82035052

"If it is straightforward to get higher yield without default risk, doesn’t that suggest it’s an easy game to play?"

Sure it is. You just take on more credit risk than the index. For example, in Golan's IG fund, he's benchmarking against the BofA Global Large Cap Corporate Index. However, most of his holdings are either side of the junk border:

Rating	Man_Global_IG	BofA_Global_Large_Cap
Above BBB	8%	64%
BBB	68%	36%
BB	7%	0%
B	11%	0%

This strategy gives him a YTM of 6.9% and a running yield of 6%. That's somewhere in the region of 2.5% above the index, so it explains some but not all of the excess returns. The rest would presumably come from trading and the use of derivatives to magnify returns.

You've previously posted an article discussing historic default rates at different credit ratings, and more recently, defaults have been even lower than historic norms due to government support during crises and a lack of a really nasty recession. If there were some sort of economic meltdown, it may be quite a different story, but in the current economic era, defaults can be pretty much ignored.

"He generally holds short-medium in his BBB/junk funds, though he also has IG-titled funds to attract more conventional money. But surely pull-to-par will provide minimal gain unless he has found a bargain; a ‘correctly’ priced bond will trade at par throughout its life, simply returning the coupon Linton is asking for."

The "correct" price for a bond is a moving target. I doubt any bond trades at par throughout its life. Even government bonds fluctuate quite a bit in price; junk bonds will do so to a greater extent.

In his IG fund, Golan can invest up to 30% in emerging markets and can invest in unrated bonds. Quoting your earlier post, he "says he looks for bonds which are underpriced and sells a bond when it reaches fair value". This would require bonds that don't trade at par throughout their life.

I note that some of his top 10 holdings are currently trading above par, meaning they could be regarded as underpriced at launch. That may be symptomatic of bonds that launched before interest rates were hiked from historic lows. Perhaps he will sell these early to avoid a pull-to-par loss. Recently launched bonds will have been priced against much higher rate expectations. It doesn't look like a fuller list of holdings is available, and in any case would probably prove quite difficult to analyse.

aroominyork

You just take on more credit risk than the index.

Though the strategy doesn’t work if those bonds default…

…in the current economic era, defaults can be pretty much ignored.

Doesn’t that beg the question of why anyone holds high quality bonds at the moment?

This strategy gives him a YTM of 6.9% and a running yield of 6%. That's somewhere in the region of 2.5% above the index, so it explains some but not all of the excess returns. The rest would presumably come from trading and the use of derivatives to magnify returns.

As you know, derivatives are not my area of expertise, but “presumably come from trading” sits at the heart of his approach – buy when underpriced and sell when fairly priced.

He had been in the bond game since 2013 and managing funds since 2017 (four years at Schroders before moving to Man) so he’s not been through a serious crash. Hopefully his skillset will hold up as and when that happens.

I note that some of his top 10 holdings are currently trading above par, meaning they could be regarded as underpriced at launch. That may be symptomatic of bonds that launched before interest rates were hiked from historic lows. Perhaps he will sell these early to avoid a pull-to-par loss.

Or perhaps they have whopping great coupons that compensate for the pull-to-par. That would presumably show itself - if* replicated across the portfolio - as high income and a capital loss. (* Obviously this wouldn’t happen; I say it to illustrate the point.)

masonic

https://forums.moneysavingexpert.com/discussion/comment/82035971#Comment_82035971

"Though the strategy doesn’t work if those bonds default…"

Sadly, it looks like the article "Finding value by stepping down in quality" that had some data on this has been pulled from the New York Life Investment Management website. However, I was able to retrieve the historical 0.36% default rate for BB- bonds. One would need to be quite unlucky to have selected a mix of BBB-B bonds in which defaults swallowed up more of your returns than the fund fee does. That is not to say there will not be some unknown event in the future that changes that.

"Doesn’t that beg the question of why anyone holds high quality bonds at the moment?"

It does. I think it's fair to say most active funds with the mandate to do so are tilting towards lower credit ratings. Indexes are based on market capitalisation, and the largest borrowers tend to have high credit ratings, some better than some countries!

But it is important to understand that one can lose money without there being a default. If there is a major downturn, then suddenly investors will want to be compensated for the additional perceived risk. That will widen credit spreads, which will have much less effect on high quality bonds. If you need to get off the ride at some point in the near future, you would not want to do so while holding junk bonds in a recession.

"As you know, derivatives are not my area of expertise, but “presumably come from trading” sits at the heart of his approach – buy when underpriced and sell when fairly priced.

He had been in the bond game since 2013 and managing funds since 2017 (four years at Schroders before moving to Man) so he’s not been through a serious crash. Hopefully his skillset will hold up as and when that happens."

Hope springs eternal. I remember that Richard Woolnough sailed through the global financial crisis with his M&G Optimal Income fund (10% drawdown vs 20% sector average), yet got it wrong during Covid (15% drawdown vs 10% sector average) and the 2022 inflation spike (17% drawdown, in line with sector average).

Golan's approach is somewhat more risky, so a >20% drawdown is not out of the question. Perhaps it will not come for many years and investors will have a healthy cushion of excess returns by then. Arguably early investors already have.

"Or perhaps they have whopping great coupons that compensate for the pull-to-par. That would presumably show itself - if* replicated across the portfolio - as high income and a capital loss. (* Obviously this wouldn’t happen; I say it to illustrate the point.)"

His top holding in the IG fund is RLGH Finance Bermuda Limited, which has a coupon of 6.75% and is only trading a few points above par with 9 years to maturity. So those do exist too.