Bond funds have been well received this year, according to data from the Hong Kong Investment Funds Association. Can the trend continue?
Since Donald Trump was elected US president in November, investors have been expecting a faster interest rate hike cycle than six months ago. If that happens, it could trigger a rotation of capital toward equities from bonds.
However, “a pending US interest-rate hike and worries about inflation may have persuaded investors to start avoiding bonds. We think that’s a mistake, especially when it comes to high yield, a sector that often thrives when rates rise”, AB said in a recent research note.
The pending uncertainties mean investors will maintain a bias to short-term duration bonds and strategies until that picture becomes clearer, said Roger Bacon, Citi Private Bank’s Asia-Pacific head of managed investment.
Against this backdrop, Mara Dobrescu, Morningstar associate director of fixed income strategies based in London, provides a comparative analysis of two US high-yield funds – the Axa World Funds US High Yield Bonds Fund with the Pimco Funds Global Investors Series plc US High Yield Bond Fund.
Mara Dobrescu, Morningstar associate director of fixed income strategies
Investment strategy
A main difference between the two products is that the Axa fund has a higher risk profile than the Pimco fund, as reflected in the allocation to CCC-rated bonds (the Below B category):
| Instrument | Axa fund (%) as of Aug 31 |
PIMCO fund (%) as of Sept 30 |
| AAA | 0 | 13 |
| BBB | 6.2 | 3 |
| BB | 24.3 | 32 |
| B | 42.6 | 40 |
| Below B | 20 | 12 |
| Not rated | 6.9 | 0 |
| Cash | 4.3 | 2.6 |
Source: Morningstar
“The manager focuses on generating incremental yield return rather than betting on an increase in the price of the bonds. Thus, he does not hesitate to invest a significant portion of the portfolio in poorly-rated securities (CCC) with higher yields,” as they are believed to be strong enough to avoid default until the bond reaches maturity, Dobrescu explained.
The Axa fund has had an average 25.4% allocation toward CCC-rated securites during the past three years, compared to 9.9% in the Morningstar’s USD high yield bond category.
The fund has a bottom-up issuer analysis, with a largely buy-and-hold approach, she said.
“In fact, the manager rarely invests in issuance and prefers to wait until the bonds are approaching maturity to buy them when their risk profile decreases.”
The Axa fund has a limit of 5% overweighting per sector, with no limit in case of underweight, meaning the fund can be entirely absent from a benchmark sector.
“For example, the manager has historically shied away from financials, because he believes that by the time a bank gets downgraded to high yield, default is right around the corner, so there is no value to being invested there.”
By comparison, the Pimco product has a more flexible approach, with bias toward higher-quality credits.
It has historically been focused on BB and B-rated names, which the manager deems to have the most attractive risk-return trade-off, Dobrescu said.
In March 2015, the fund’s benchmark was changed to the BofA ML US High Yield Constrained Index and the maximum allocation to CCC bonds was increased to 30%.
The move was to give investors a broader opportunity set, and to allow the manager a bit more latitude than in the past, she explained.
Still, “looking at the fund’s portfolio, many of the lower-rated bonds have in fact short maturities and a fairly low beta, which helps limit their risk,” she noted.
In terms of sector weighting, both funds are overweight healthcare – Axa fund has about 4% more than the benchmark (BofA Merrill Lynch US High Yield Master II index), while Pimco has 2.8% more than its benchmark BofA ML US High Yield Constrained Index.
“The Pimco fund does not have a formal limit in terms of sector allocation: the manager can allocate freely, depending on where he sees market opportunities at any given time.
“Duration is not typically used by these funds as a significant driver of performance, so there’s not much to say about that,” she added.
The Axa fund also has never considered using credit default swaps (CDS) due to investors’ demand for a “pure” high yield product, she noted. With the Pimco product, “there is a large desk of managers and traders who are well-versed in derivatives strategies, so we are quite confident in their ability to execute.”
Performance
Both the Axa and Pimco funds underperformed their benchmark indices over the three-year period, as shown in the chart below.
The two products also managed to limit losses that plagued many high yield bond funds during the commodity sell-off in 2014 and 2015, Dobrescu said.
