Bond funds set to break two-year losing streak

But the sharp fall in rates since late October, by as much as 60 basis points, has sparked a near 7 per cent rally in long-dated Australian bonds, rewarding managers that took on the duration risk.

The performance of funds for the year to November 30 ranged from 8.1 per cent – for an interest rate hedged corporate bond exchange-traded fund managed by Betashares – to minus 1.46 per cent, which was the case for Ardea Asset Management, the only fund of Morningstar’s list of 86 that had negative returns.

Comparing and analysing the performance of bond funds, however, can be complex because the various categories within the fixed-income universe can produce an array of outcomes, while investment mandates or strategies also vary among portfolio managers.

Some fixed-income funds closely track the bond benchmark and are sensitive to interest rate moves; others focus on corporate debt and target an absolute return, typically measured as a margin over the cash rate.

The “Bonds-Australia” funds is one of 10 fixed-income categories classified by Morningstar, alongside “diversified credit” or “bonds inflation-linked” or “bonds global Australia”.

Among all bond funds rated by Morningstar, Mr Little singled out Janus Henderson’s tactical income fund. Its lower duration strategy and credit positioning placed it among his top performers, with 4.7 per cent absolute returns.

Mr Little said Janus was a top performer because it did not try to manage interest rate risk to the benchmark. Instead, it targeted absolute returns.

Another key element that underpinned its performance was a robust corporate debt environment, despite the Reserve Bank’s 4.25 percentage points worth of increases in borrowing costs since last year to tame stubbornly high inflation.

‘A couple of challenging years’

“Managers were rewarded for holding credit, which surprised some because people were expecting the economy to soften more than it has,” Mr Little said.

Global bond giant Pimco’s Australian bond fund was another favourite, largely because as one of the world’s largest fixed-income managers, it was backed by a huge global research engine.

“It hasn’t been a straight line for them, but they’ve had a good 12 months,” said Mr Little. The fund has generated 2.7 per cent in absolute returns this year.

“It’s been a couple of challenging years across all bond categories, but it’s been a more positive one this year,” Mr Little said.

Even so, some portfolio managers lagged their peers because they increased duration – i.e. they increased their exposure to changes in interest rates – too early and moved their positions to defensive assets because they thought the economy would tip into a recession, Morningstar added.

That was the case with Bentham Asset Management and T. Rowe Price, it said. Their funds are classified under Morningstar’s “unconstrained fixed income” category.

Mr Little noted that T. Rowe Price’s dynamic global bond fund, which posted 5 per cent in negative returns, had flipped its 2022 short-duration strategy because it saw better value elsewhere.

In the case of Bentham’s global income fund, the portfolio manager switched to a defensive position mid-year and maintained high credit risk.

“They could have done better,” he said, stressing that the fund’s 3.7 per cent in returns this year was still OK. He noted that Daintree and Kapstream, which have credit exposure, performed better than Bentham because they opted for less interest rate risk.

Although the coming year looks encouraging for bonds as central banks appear at the end of their tightening cycle, Mr Little warns that debt defaults could arise if persistently high inflation prompts more rate increases.

“It does not appear that there would be a lot of defaults in investment grade credit, but there are likely to be areas of stresses over the next 12 months,” he added.

Healthy balance sheets

“If there is a soft landing, it should be a good environment for fixed-income managers. It just depends on what credit spreads do.”

Ratings agencies are generally confident that Australian corporate borrowers will be able to weather higher borrowing costs and steeper prices thanks to their healthy balance sheets.

“Any pockets of stress are more likely to be seen in smaller businesses that have less financial flexibility to manage through this period,” said Kelly Amato, a senior director at Fitch Ratings.

S&P Global also noted that some companies might not be able to pass through cost increases as consumers curbed spending.

“Such a trend could pressure operating margins over the next 12 months,” said S&P analyst Richard Creed.

– with Jonathan Shapiro