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nterest rate cuts are on the horizon, and quality corporate bond yields are extremely attractive with some comparable to those of the global financial crisis era. At the short end
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short-dated bonds
‘Yields today are the most attractive since the 2008 Global Financial Crisis’
Actively exploiting yield in short-dated bonds
Opportunities abound amidst fixed income ‘cushion’
Disclaimer Past performance is not a guarantee or a reliable indicator of future results.The Fund will be actively managed in reference to the Bloomberg Barclays MSCI Global Green Bond Index as further outlined in the Prospectus and Key Investor Information Document. Performance and fees Past performance is not a guarantee or a reliable indicator of future results. Performance figures are presented net of management fees commissions, other expenses, and the deduction of actual investment advisory fees; but do not reflect the deduction of custodial fees. The "net of fees" performance figures above also reflect the reinvestment of earnings. All periods longer than one year are annualized. Separate account clients may elect to include PIMCO sector funds in their portfolio; sector funds may be subject to additional terms and fees. Charts Performance results for certain charts and graphs may be limited by data ranges specified on those charts and graphs; different time periods may produce different results. ESG Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by PIMCO will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and PIMCO is dependent on such information to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful. Past performance is not a guarantee or reliable indicator of future results. For professional use only The services and products described in this communication are only available to professional clients as defined in the Financial Conduct Authority's Handbook. This communication is not a public offer and individual investors should not rely on this document. Opinion and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness.The services and products described in this communication are only available to professional clients as defined in the MiFiD II Directive 2014/65/EU Annex II Handbook and its implementation of local rules. This communication is not a public offer and individual investors should not rely on this document. Opinion and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Europe GmbH Irish Branch (Company No. 909462) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG). The Italian Branch, Irish Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; and (3) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.
Time to realise the impact of short-dated credit
The next rate move is down
Important information
Case Study – JICA Deep Dive
In this Spotlight guide, we discuss how fixed income portfolios should be positioned ahead of a rate cutting cycle and why investors should consider moving from cash to quality short-dated corporate bonds. We look at how active managers can exploit opportunities created by passive trading to extract further yield. Finally, we explore why a disciplined investment approach aims to deliver an excess yield over the index by locking in attractive yields and holding through to maturity.
“We’re now into a phase where we can say with a relatively high degree of confidence that we're past the peak in rates, and the next move is down. This is the next big move in the markets to play for”
This is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. The value of investments in overseas markets may be affected by changes in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. They can also use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0424/386592/SSO/NA
For investment professionals only. Capital at risk.
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Why investors may want to consider moving from cash to corporate bonds
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Impact investing: Where are we now?
Going global for more impact
FUND SNAPSHOT
Social ratings: Methodology overview
of the curve, the current economic backdrop means corporate bonds are offering particularly attractive returns.
nterest rate cuts are on the horizon, and quality corporate bond yields are extremely attractive with some comparable to those of the global financial crisis era. At the short end of the curve, the current economic backdrop means corporate bonds are offering particularly attractive returns.
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Ensuring fixed income portfolios are appropriately positioned ahead of a rate cutting cycle will be essential to taking advantage of higher yielding opportunities in 2024, say Fidelity fund managers Kris Atkinson and Shamil Gohil
Interest rates and inflation have dominated investor conversations over the past few years, not least for their impact on fixed income markets. Investors have been caught off guard by inflation movements and GDP data, whilst views on the Monetary Policy Committee’s (MPC) next move continue to be debated.
What is impact investing?
According to the group’s Global CIO for Fixed Income, Steve Ellis, one of the core reasons for why fixed income markets are so in vogue is due to ‘all-in’ yields - a combination of core yields and the spread component - which are at very attractive levels in comparison to the past decade.
A cushioned environment
“Credit spreads are at very tight levels, in both US dollar and euro high yield and investment grade,” explains Ellis. “But the reality is that the all-in yield is extremely enticing and so we are seeing investors taking comfort from the fact there is plenty of cushion in the sector - a lot has to go wrong (in terms of core yields moving higher or credit spreads widening) to see losses.”
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Blue bonds: long-awaited innovation or yet to make a splash?
For Kris Atkinson and Shamil Gohil, managers of the £496m* Fidelity Short Dated Corporate Bond fund, the debate has now come to a head, and they are confident that rates have peaked as data trends downwards. Indeed, the question is no longer if the Bank of England (BoE) hikes rates again, but when it cuts.
“We’re now into a phase where we can say with a relatively high degree of confidence that we're past the peak in rates, and the next move is down,” explains Atkinson, who notes the case for rate cuts is strengthened by inflation receding and growth stagnating. “This is the next big move in the markets to play for”.
To further illustrate this point, Ellis refers to ‘wipeout’ yields which reveal how much of a ‘cushion’ is available for a rise in yields. Standing at a 10-year high, current wipeout yields show that yields in US high yield can rise from the current level of 7.6% to 10% - either through wider spreads and/or higher core yields - before total returns are eliminated.
Against this backdrop, there is less of a need to invest in higher risk assets to secure a decent yield and the managers are focused on high-quality issuers, particularly in defensive areas which still offer opportunities for investors.
Post-recession positions
For example, looking across the fixed income market, sterling investment grade bonds are no longer historically cheap but compared to the high yield market are more attractive, says Gohil.
Sources:
* Fidelity International, as at 31 March 2024 ** The Investment Association; March 2024
Sources.
nterest rates and inflation have dominated investor conversations over the past few years, not least for their impact on fixed income markets. Investors have been caught off guard by inflation movements and GDP data, whilst views on the Monetary Policy
Committee’s (MPC) next move continue to be debated.
higher core yields mean that there is a built-in cushion protecting total returns
Wipeout yields show that there would need to be a large change in absolute yield levels to wide out carry
Wipeout yields remain at 10-year highs
Feb 14
US IG
US HY
EURO IG
EURO HY
Feb 15
Feb 16
Feb 17
Feb 18
Feb 19
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This cushion is perhaps most prevalent in the shorter duration part of the curve; which offers value in comparison to longer dated credits. Gohil explains: “In the Fidelity Short Dated Corporate Bond fund where yields are running at around 6% with duration at just under three years; the wipeout yield is at around 200 basis points (bps). In real terms that means if you saw 100bps of spread widening and a 100bps move higher in gilts – moves similar to the LDI crisis in October 2022 – we would still breakeven on our investments in one year’s time.”
“If you look at the FTSE dividend yield at 4% and with global equities at all-time highs again, I know where I'd rather park my cash or invest moving into the late cycle recessionary environment. For me, it still feels like a good place to hide,” he says.
Atkinson agrees whilst noting investment grade companies also remain “pretty resilient”, with companies in this area generally large, diverse, and often multi-national. Within this sector the duo prefer the short-dated (sub-five year) part of the curve – namely because they can be more positively impacted by rate cuts as well as, in certain areas, offering higher yields for less risk given the inversion of the yield curve.
“In a stagnant and modest recessionary environment these companies are pretty robust,” he says. “It also takes a long time for them to mark-to-market their current debt stack to the new interest rate environment. If they've been managed in a competent way, they will not have much in the way of short-term maturities that need to be refinanced.”
Yet it could be argued that with cash boasting such attractive yields, investors should still be parking their investments in savings accounts or money market funds instead of bonds. This sentiment resonated with retail investors last year with £2.2bn allocated to money market funds in Q4 of 2023**, making it the best-selling asset class; followed by fixed Income.
But in a new era of declining rates and inflation, the Fidelity managers highlight several risks to favouring cash in 2024.
“Cash yields are relatively high, but you have reinvestment risk,” said Atkinson. “As and when the Bank of England starts cutting rates, your level of interest will go down. Secondly, by focusing on short-dated bonds you get the benefit of that inverted yield curve, as well as a little bit of duration, which is very important when rates drop.
“When rates start to fall, that will offer some capital appreciation at the front end of the curve, and it will offset any spread widening that you may or may not see in credit. So short-dated credit is better than cash in pretty much every case.”
Cash versus bonds?
High-quality fixed income is looking more attractive from an income perspective
Yields are at levels not seen since the global financial crisis era
Sterling IG credit offers a compelling yield over the FTSE All Share
'02
'04
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'06
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
'18
'19
'20
Sterling IG Credit Yield
FTSE All-Share Dividend Yield
'03
'17
9%
7%
6%
5%
4%
3%
2%
1%
0%
8%
Aug 14
Aug 15
Aug 16
Aug 17
Aug 18
Aug 19
Aug 20
Aug 21
Aug 22
Aug 23
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
'21
'22
'23
'24
Source: Fidelity International, Bloomberg, 29 February 2024. Equity Gross Aggregate dividend yield represented using the FTSE All Share Index. Sterling IG Credit = ICE BofA Sterling Corporate & Collateralized Index.
Source: Fidelity International, ICE. BofA Indices 29 February 2024.
n a world marked by increasing economic inequality and environmental challenges, the need for innovative investment solutions that address both financial
nterest rates and inflation have dominated investor conversations over the past few years, not least for their impact on fixed income markets. Investors have been caught off guard by inflation movements and GDP data, whilst views on the Monetary Policy Committee’s (MPC) next move continue to be debated.
Impact investing involves the measurement and reporting of the impact of environmentally and socially conscious investments. In contrast, environmental, social, and governance (ESG) investing refers to the funding of companies that are aligned with an investor’s ESG aims, but do not have the same obligation to prove that investments are delivering measurable outcomes.
Yet it could be argued that with cash boasting such attractive yields, investors should still be parking their investments in savings accounts or money market funds instead of bonds. This sentiment resonated with retail investors last year will £2.2bn allocated to money market funds in Q4 of 2023**, making it the best-selling asset class; followed by fixed Income.
As markets reach an inflection point in the interest rate cycle, investors need to look at how active managers can exploit opportunities created by passive trading and extract further yield from the market
hort-dated credit has been high demand in recent years and many retail investors opted for passive funds to gain exposure. According to Morningstar, passive fixed income funds in 2023 saw estimated new flows of £241bn,
S
According to Ben Deane, Fixed Income Investment Director at Fidelity, this presents an opportunity for active investors, by being able to take out-of-index exposure.
“Furthermore, the 5-6-year part of the curve is quite steep and we are able to effectively let those bonds roll down.”
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Tammie Tang, the portfolio manager leading Columbia Threadneedle Investments’ social bond strategies, and Charlotte Finch, client portfolio manager, share the thought process behind the launch of the CT Global Social Bond Fund in addition to their UK and European focused portfolios.
In a passive approach the fund replicates the benchmark, meaning regular rebalancing, higher turnover and increased transaction costs. Overall, passive funds also tend to underperform indices on a net basis due to these fees. Within short-dated credit this underperformance is even more pronounced and often means passive performance for this asset class can be “sub-optimal”.
Sub-optimal performance?
The figures support this consensus. The passive short-dated fund with the longest running track record in the IA £ Corporate Bond sector has delivered an average calendar year underperformance of 0.15% versus its respective index since inception in 2014. Considering the average calendar year return from the index was 1.5% over the period (2014 to 2023), a 0.15% underperformance is almost 10% of total return lost.
Passives are also known for their elevated trading levels, but this is exacerbated in the short-dated market where the fund managers note new bonds are constantly entering and leaving the 1-5-year index as they move towards maturity. As a result, passive funds are forced to buy and sell at either end of the maturity spectrum.
Out of index exposure
The managers ability to dig into these sectors and find attractive investments allows them to identify opportunities some fund houses will be less likely to access.
Meanwhile, Atkinson explains another area the team can add value via actively managing short duration bonds is in ‘complex’ credit, such as asset-backed securities, or opportunities within regulated utilities such as the water sector.
Complex opportunities
“The most important thing is the impact of the underlying projects”
But with 2024 almost certainly set for an interest rate cut, there is cause to rethink this passive position and particularly when drilling down into asset classes such as short-dated credit.
Furthermore, passives are also beholden to issuance in the market. This is no surprise, but it does mean investors are more exposed to bigger names that tend to have higher leverage, according to Gohil.
“When the market is volatile, we as active investors tend to overweight and underweight, and where there tend to be bargains relative to fundamental quality, we can overweight those names in time. But a passive vehicle owns the market weight by default.”
“Asset-backed securities, and we count sectors that have physical assets behind them too, offer a defensive asset at good value. Similarly in the regulated utilities space we like the water sector, which despite news headlines remains recession and inflation proof, highly regulated and pretty cheap. These are areas we see a lot of value in and, as active managers, we feel we have an edge because of the corporate access we have to businesses. We know and understand the bond documentation, the regulatory framework, how that intersects with government policy, and our insight has allowed us to take a high conviction view on it.”
Source: *Morningstar; March 2024
“If you think about a one- to five-year benchmark that passive funds track, you are restricted to buying 1-year to 5-year bonds. When a bond moves less than 1-year to mature, you are a forced seller,” he explains. “This presents a good buying opportunity for active investors. Likewise, active investors can by 5.5-year maturity bonds before they enter the one- to five-year benchmark and therefore benefit from forced passive buying as these bonds fall into the benchmark.
compared to £43.2bn into active funds. Roughly a quarter of the all-maturity sterling corporate bond market is passive (£12bn out of £48bn) compared to almost half of the short dated market (£4.3bn out of £10bn)*.
“The market has been beta chasing and that is why we have seen the growth of passives in recent years. But now relative value is becoming more and more important because of volatility and higher dispersion. This is where active investors will be able to generate more alpha,” says Shamil Gohil, manager of the £496m Fidelity Short Dated Corporate Bond Fund.
Kris Atkinson, lead portfolio manager on the strategy agrees citing recent economic tailwinds have increased the opportunity set for active managers in short duration greatly. “After a long time, central banks are no longer the influence they used to be. And we are already seeing more dispersion between asset classes and investments on both the credit and equity side. As growth trends lower, it stands to reason that we are going to see more of that, so there are many more opportunities for us to take advantage of now.”
Fidelity short dated corporate bond fund performance overview
Fund (Net)
Index
YTD
1 Year
3 Year Ann
5 Year Ann
since inception ann
8
4
3
2
1
0
-1
Fidelity Short Dated Corporate Bond Fund
ICE BofA 1-5 Year Eurosterling Index
-0.6%
0.3%
Mar 19 - Mar 20
Mar 20 - Mar 21
6.5%
4.5%
Mar 21 - Mar 22
-1.9%
-3.2%
Mar 22 - Mar 23
-2.6%
-3.1%
Mar 23 - Mar 24
7.1%
5.8%
Source: Fidelity International, 31 March 2024. Performance reflects Fidelity Short Dated Corporate Bond Fund W Income Shares. Basis Bid-Bid with income reinvested in GBP.
Kris Atkinson, fund manager
“Relative value is becoming more and more important because of volatility and higher dispersion”
5
7
6
12 month rolling returns
nterest rates and inflation have dominated investor conversations over the past few years, not least for their impact on fixed income markets. Investors have been
hort-dated credit has been high demand in recent years and many retail investors opted for passive funds to gain exposure. According to Morningstar, passive fixed income funds in 2023 saw estimated new flows of £241bn, compared to £43.2bn into active funds. Roughly a quarter of the all-maturity sterling corporate bond market is passive (£12bn out of £48bn) compared to almost half of the short dated market (£4.3bn out of £10bn)*.
Sources: *Morningstar; March 2024
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Kris Atkinson and Shamil Gohil, portfolio managers of the Fidelity Short Dated Corporate Bond Fund, explain how the team is buying duration to lock in higher yield opportunities that may not be around next year
Our disciplined investment approach aims to deliver an excess yield over the index by locking in attractive yields and holding through to maturity.
What is the investment process on the Fidelity Short-Dated Corporate Bond Fund?
(L-R) Andrew Brown, portfolio manager; Letty Byatt, social impact analyst; Tammie Tang, lead portfolio manager; Andrew Dewar, deputy portfolio manager; Charlotte Finch, client portfolio manager
Quantitative assessment of the social 'intensity', across 9 measures (to score within 0 to 31)
Social intensity
Social mapping (who, where)
Socio-economic/Deprivation focus Regional score Positive peace score
(max 4) (max 4) (max 2)
Social hierarchy of needs Additionality (new funding) Additive, secondary benefits Funding usage (social targetting)
(max 5) (max 5) (max 2) (max 2)
Social focus (what)
Quality of reporting Clarity of impact
(max 2) (max 5)
Impact transparency
TOTAL
(max 31)
“Once we have identified our social investment opportunity set, our analysis starts with the financial opportunity”
Our process to do this is simple: we buy credit, harvest the premium and lock that into the fund. We focus on high quality short-dated corporate bonds, and we select those with the help of a team of credit analysts that are based here in London and globally. They provide us with a pool of high-quality credit ideas and options where there is a strong conviction that we will be paid with capital and interest.
How do you lock in yield?
Firstly, we generate an excess yield over the index via three active strategies: underweight quasi-sovereign and supranational bonds; selective exposure to callable financials; and conservative high yield positioning (capped at 10%).
Fixed income markets are semi-efficient and typically over time the credit premium you earn will more than compensate for your default risk. That additional premium is typically referred to as the liquidity premium. If you are buying and holding bonds to maturity you are typically harvesting that liquidity premium and taking advantage of incorrect pricing in the market. And this is how we lock in yield.
Furthermore, by taking advantage of passive funds that are forced to buy bonds when they enter the index, and forced to sell when they exit. It gives us the opportunity to take advantage of some of the best credit ideas.
The key drivers of performance recently have been credit selection, and the yield advantage that we earn over the benchmark and our peers. We tend not to generate alpha via complex duration or derivative strategies.
What has driven performance in the fund in recent months?
Over the calendar year of 2023, the fund has returned 8.1% compared to the comparative index return of 6.9%. Over the same timeframe the Fund has offered a higher yield compared to the index yield. Currently this yield is 5.9% versus 5.3% for the index (to February 2024).
Firstly, it is our intensive focus on credit work. We have our large team of analysts that look to exploit mis-pricings in the market. These mis-pricings occur due to technical factors already mentioned - investors that are forced buyers and sellers, and the fact that markets tend to panic. Having the firepower to take advantage of that alongside a credit team and analysts that not only understand what is going on under the hood but have already done their homework in terms of the opportunity on offer gives us a strategic advantage.
What sets this fund apart from other short-dated investment grade bond funds?
We also have our analysts researching parts of the market that are less well understood than our peers - for example in the asset-backed space in the UK. Having analysts that can dig deep into those areas and really understand them gives us an edge and allows us to cover less well-known names in the market to extract liquidity premium, complexity or structural premium.
Given current economic conditions, we believe now is a very good time to hold short-dated bonds as higher interest rates have resulted in an inversion of the yield curve, which benefits corporate bonds at the front end of the yield curve. The yields currently on offer within corporate bonds are comparable to those of the 2008 global financial crisis - they are extremely attractive.
What is your market outlook for 2024?
We are buying duration to lock in these higher yields while we still have the chance, as these yields may not be around in a few years’ time.
With rate cuts on the horizon, we continue to like high quality corporate bonds, particularly given the additional yield advantage (via the credit spread) over government bonds. We particularly like short-dated credit as the short end of the curve is influenced more by monetary policy than the longer end of the curve which, in a cutting cycle, means there can be a larger positive interest rate impact.
“Our process is simple: we buy credit, harvest the premium and lock that into the fund”
Kris Atkinson; 24 years’ experience
2013 –
2010 –
2000 –
Promoted to portfolio manager
Promoted to senior credit analyst
Joined Fidelity
Fixed income portfolio manager, Fidelity
2023 –
Co-head of global fixed income solutions
2022 –
Head of UK credit solutions, HSBC
2019 –
Shamil Gohil; 18 years’ experience
Credit portfolio manager, BlackRock
2011 –
Credit trading and portfolio management, PIMCO
2006 –
•
Ongoing*
*Fidelity International as at March 2024. Please note that this data is unaudited.
Supported by 50 credit analysts and quantitative analysts
Work closely with 25 portfolio managers within the Fidelity fixed income team which is led by global CIO for fixed income Steve Ellis
Calendar year performance
2019
4.4%
3.9%
2020
2.9%
3.1%
2021
-1.0%
2022
-6.6%
-7.3%
2023
8.1%
6.9%
Source: Fidelity International, Morningstar, 31 December 2024. Performance reflects Fidelity Short Dated Corporate Bond Fund W Income Shares, basis Bid-Bid with income reinvested in GBP. Comparative Index: ICE BofA 1-5 Year Eurosterling Index.
Over the calendar year of 2023, the fund has returned 8.4% compared to the comparative index return of 6.9%. Over the same timeframe the Fund has offered a higher yield compared to the index yield. Currently this yield is 5.9% versus 5.3% for the index (to February 2024).
With interest rate cuts from central banks on the horizon, investors that piled into cash and money market funds may want to consider moving some of that cash exposure elsewhere. Ben Deane, investment director, Fixed Income - Fidelity International, outlines why a first step is short dated high quality corporate bonds and then all-maturity corporate bonds once the curve dis-inverts
ssets in money market funds are close to $6tn, having doubled from the asset level pre-pandemic, with Fidelity’s money market funds seeing strong asset growth too. This makes sense, for investors used to almost zero rates for the
A
The negative drivers of bond returns - inflation and interest rate hikes - are abating which sets fixed income up well for the period ahead. Inflation is moderating and central bankers are now talking about the timing of interest rate cuts. Accordingly, the market is now pricing in the first full 0.25% cut from the Bank of England (BoE) by August 2024, with the chances of a cut earlier in June.
Interest rate cuts are just around the corner
Blue bonds - a long-awaited innovation?
markets, but were issuing labelled sustainability bonds in the Japanese market. We knew they could bring a sustainability labelled issuance to these major markets.
Byatt explains that when they put a bond into the fund, they link it with a UN Sustainable Development Goal as well as link it to at least one of the underlying targets. In the case of JICA, it was mainly supporting infrastructure.
Social impact
Citing a particular JICA project in Delhi, India, Byatt explains how JICA addressed social outcomes including gender with the construction of a railway. While the railway already had a huge social benefit as it allowed people to get into the main city for work, shopping, and schools, the project went the extra mile by including a women-only carriage with a security guard during rush hour.
decade following the Global Financial Crisis the prospect of >5% yields from low-risk cash investments was, and is, attractive.
As our money market team attest here, the case for cash remains strong. There will always be a need for cash, particularly for those investors prioritising liquidity and capital preservation. However, some investors may be allocating to cash for the prospect of outperformance versus other asset classes. While this was the right call in recent years (cash outperformed most asset classes in 2022, for example), those investors might want to consider corporate bonds looking ahead.
Ahead of a cutting cycle cash rates are elevated because, like today, they tend to have followed a series of rate hikes which optically makes cash look attractive from a forward-looking return standpoint. As the chart below shows, today investors can generate an attractive yield to maturity from cash, which is similar to corporate bonds.
Cash offers an attractive yield to maturity
So, why bother with corporate bonds if you can get more-or-less the same level of yield from cash? Firstly, cash is more exposed to reinvestment risk. Reinvestment risk refers to the risk that investors are unable to reinvest cashflows, such as coupons or principal, at a rate comparable to the current rate of return. As rates fall, cash and money market instruments are more exposed to this risk given these securities often have maturities measured in days (rather than years). This means cash yields (and returns) more closely follow central bank rates lower relative to bonds.
With rates expected to fall, it might be time to consider corporate bonds
On the flipside, fixed income securities have a fixed income for a longer period of time and the value of those cash flows rises as interest rates fall. This impact is known as duration risk, a measure of the sensitivity of the price of a debt instrument to a change in interest rates (yields fall, prices rise). So, if central banks are due to cut rates, time to add as much duration as possible? Not quite, for two reasons. Firstly, markets tend to price in cuts before they happen and so the extent of the rally in bonds during a cutting cycle depends on how many cuts were already priced in. Secondly, as we highlight here, if the yield curve is inverted, like today, then short dated bonds can outperform longer dated bonds as the curve normalises despite having less duration risk. In these unique circumstances your position on the curve can be a more powerful driver of return than the absolute level of duration. The curve inversion makes us particularly constructive on 1-5yr corporate bonds.
Finally, through active management, we can pick those bonds with a more attractive level of yield per unit of risk to generate an excess yield over cash and comparable indices. For example, while the 1-5yr corporate bond market offers a yield of 5.2%, the yield to maturity on Fidelity Short Dated Corporate Bond (Fidelity’s active 1-5yr corporate bond fund) is 5.8%.
If history is a useful guide, with rate cuts around the corner, it seems unlikely that cash will outperform safer bond assets again, but it may outperform high yield and equities. Bonds offer an attractive proposition as a first step back in, and particularly short dated corporate bonds for the more conservative investor. This is because bonds tend to perform well as central banks cut interest rates and - with the front end of the curve more sensitive to interest rate policy, and yield curves inverted - short dated bonds could stand to benefit more in the earlier phases of the cutting cycle. The chart below shows the 1yr return from different assets starting 3-months prior to the first BoE cut. If the BoE cut in December we started the return series in September, to account for markets pricing in cuts ahead of time and to make this a more useful guide for investors today (with cuts priced in over the next few months).
History suggests high quality bonds tend to perform well versus cash in cutting cycles
The chart shows that investment grade corporate bonds (short dated and all-maturity) and all maturity government bonds tend to perform well in cutting cycles with excess returns generated over cash (on average) over 1yr. High yield bonds show mixed results, down versus cash on average over 1yr. Equities have on average underperformed cash through rate cutting cycles with the DotCom and Global Financial Crisis crash being the primary reasons for the poor overall average versus cash.
Investors with high cash allocations tend to be risk averse, so what about the worst-case outcome, and over a longer time horizon? As the chart below shows, over a 3yr holding period, the worst excess return over cash from 1-5yr corporate bonds in the cutting cycles we identified was +3.6%. This was in the 3yrs following October 1998, when cash delivered +19.2% returns while 1-5yr corporate bonds delivered +22.8% returns.
Corporate bonds offer a relatively safe option versus cash over the longer term
In the other 3 cutting cycles, 1-5yr corporate bonds outperformed cash by even more over 3yrs (with this outperformance ranging from +5.4% to +11.8%). For high yield and equities, the worst-case outcomes were -19.8% and -37.3% respectively over 3yrs. For high yield this was in the 3yrs post October 1998 when high yield delivered -0.6% returns versus cash at +19.2%.
For equities, this was in the 3yrs following February 2001, when the FTSE 100 was down 23.8% versus cash up at +13.5%. It is also notable that the FTSE 100 was down in absolute terms over 3yrs in 3 of the 4 cutting cycles we identified. The average 3yr return from the FTSE 100 versus cash in the four cases we identity is -7.4%, this is because central banks tend to cut into weakness to stimulate the economy.
Over 5yrs following a cutting cycle, all maturity corporate bonds stand out as a relatively safe option based on history with the worst-case excess return over cash at +14.2%. This was in the 5yrs following December 1995 when cash delivered +36.7% return versus all maturity corporate bonds at +50.9%. All maturity government bonds come in second, largely due to its higher duration profile (at 9.3yrs) relative to 1-5yr corporate bonds (at 2.6yrs).
For the risk averse investor looking to outperform cash in the medium term we think corporate bonds are set up well as the BoE starts to cut. Furthermore, with the yield curve inverted, 1-5yr corporate bonds may be an attractive option over 3yrs. Over the longer term (5yrs), all-maturity corporate bonds standout well as the curve normalises and investors can once again benefit from higher yields for taking more risk via longer dated bonds.
So why not go for government bonds as the BoE starts to cut? Firstly, we find that 1-5yr corporate bonds outperform government bonds on average in the first year following cuts and, as above, the worst-case outcomes are better in 1-5yr corporate bonds over 3yrs, while more attractive in all maturity corporate bonds over 5yrs. Why? Because investors in corporate bonds benefit from the credit spread, the additional yield for lending to corporates over government bonds. The credit spread today is roughly 1%, providing an additional tailwind to performance. This is despite the all-maturity Gilt index having much more duration than both the 1-5yr and all maturity corporate bond indices, reaffirming the notion that position on the curve is important in a cutting cycle. The credit spread also provides a mild cushion against yield rises.
Better off in government bonds?
What is the risk to this view? If rates stay on hold or the BoE start to hike. The likelihood of hikes seems low, but we cannot discount this, or a continued hold. The good news for corporate bond investors is that yields have risen materially in the last 2yrs, meaning the starting point for return from corporate bonds is attractive and it therefore takes a relatively large yield move to ‘wipe out’ a years’ worth of carry. This is known as the breakeven rate (calculated as yield to maturity divided by interest rate duration). As the chart above shows, 1-5yr corporate bonds have a breakeven rate of 2.0%, meaning yields need to rise by 2% before you lose a years’ worth of carry. 3yrs ago this breakeven rate was 0.3%. The breakeven rate for 1-5yr corporate bonds compares favourably to all maturity corporate bonds and all maturity Gilts, at 0.9% and 0.4% respectively. On balance, short dated corporate bonds seem like an attractive risk-adjusted option.
What if the BoE don’t cut? It takes a relatively large yield move to lose a years’ worth of carry
Perhaps it is time to put some of that cash into corporate bonds.
Source: Fidelity International, Bloomberg, 11 March 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index; High Yield Bonds = ICE BofA Sterling High Yield Index; FTSE 100; Sterling Cash = ICE BofA Sterling 1-Month Deposit Bid Rate Constant Maturity Index.
Cash is generating attractive yields
Source: Fidelity International, Bloomberg, March 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index; High Yield Corporate Bonds = ICE BofA US High Yield Index used for the first cutting cycle, while ICE BofA Global High Yield Index (GBP Hedged) was used for the remaining cycles; Equities = FTSE 100. Cash rate was ICE BofA British Pound 6-Month Deposit Bid Rate Constant Maturity Index for the first cutting cycle and then the ICE BofA Sterling 1-Month Deposit Bid Rate Constant Maturity Index for the remaining 3. Uses 4 Bank of England interest rate cutting cycles between 1995 and 2024, starting in December 1995, October 1998, February 2001 and December 2007 respectively. Returns start 3-months prior to first cut to incorporate the impact of expectations.
Investment grade and government bonds perform well in BOE cutting cycles over 1 year
Cash
1-5yr Corporate Bond
All Maturity Corporate Bonds
All Maturity Government Bonds
High Yield Corporate Bonds
Equities
Sterling Cash
1-5yr Corporate Bonds
All Maturity Gilts
High Yield Bonds
FTSE 100
5.1%
5.2%
4.2%
8.6%
December 1995
October 1998
February 2001
December 2007
20.0
15.0
10.0
0.5
0.0
-5.0
-10.0
-15.0
-20.0
6.6
8.9
9.5
8.3
9.3
16.9
8.0
7.7
9.6
2.4
12.6
5.3
7.6
4.2
7.3
-14.1
5.9
2.3
-0.4
-13.1
Corporate bonds outperform cash in rate cutting cycles over 3yrs and 5yrs
3yrs
3.6
1.7
5yrs
14.2
0.9
7.8
-19.8
-8.8
-37.3
-52.7
Source: Fidelity International, Bloomberg, 11 March 2024. 1-5yr Corporate Bonds = ICE BofA 1-5 Year Eurosterling Index; All Maturity Corporate Bonds = ICE BofA Euro-Sterling Index; Government Bonds = ICE BofA UK Gilt Index. Wipeout yield is worked out as yield to maturity divided by interest rate duration and is a measure of the yield move required to ‘Wipeout’ a years’ worth of carry.
Wipeout yields for short dated credit at attractive levels
2.0
0.4
Ben Deane, investment director, Fixed Income
“Through active management, we can pick those bonds with a more attractive level of yield per unit of risk to generate an excess yield over cash and comparable indices”
This information is for investment professionals only and should not be relied upon by private investors. The value of investments and the income from them can go down as well as up so the client may get back less than they invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates rise and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Fidelity’s range of fixed income funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document (Key Information Document for Investment Trusts), current annual and semi-annual reports free of charge on request by calling 0800 368 1732. Issued by FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0324/385981/SSO/NA
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