Top Fixed Income Funds of 3Q22: While bonds enter bear market, some funds fared better than others

• Bonds sold off yet again in the third quarter and entered the bear market territory (i.e. more than -20% from the peak).

• On the back of a stronger USD, the majority of top performing funds are of either the USD or USD-hedged share class. Short duration and money market bond funds remain a staple in this year’s top performers.

• Similarly, for the bottom performing funds, their share classes are in currencies that did not perform well. Some Asian high-yield bond funds were underperformers, which can be attributed to their credit selection.

• We remain cautious of the economic outlook ahead. On a more positive note, the valuations of bonds have turned more attractive and we like global investment grade, short duration bonds.

How did fixed income funds perform in 3Q22?

Bonds were sold off yet again in the third quarter and entered the bear market territory (i.e. more than -20% from the peak, based on the Bloomberg Global Aggregate Bond Index). Nonetheless, we note that the magnitude of decline has gradually become smaller, perhaps because more investors are looking to hold bonds amidst growing risks of a recession. In line with this, the FSM Indices – All Bond fell -1.91% in SGD terms (2Q22: -5.62%).

Meanwhile, the FSM Indices – Global Bond was resilient, returning -1.92% for the quarter. Global bond yields have climbed to a high of around 4%, a level not seen since 2009, providing investors with better risk-reward from a total returns perspective.

On the other end of the spectrum, the Asian high-yield bond segment suffered the most, with the FSM Indices – Asian High Yield Bond paring off -9.83%. Towards the end of September, woes were renewed in China’s property sector after reports that CIFI Holdings (HKEX:884), one of the top 20 Chinese developers by contracted sales, had defaulted.

Table 1: Performance of various FSM Indices for fixed income funds

Note: FSM indices are a simple average of all unique fund strategies within the category listed on our platform. Investors can use it to compare a single fund against its peer-average, or its actively managed products on our platform against the market index.

Top Performing Fixed Income Funds of 3Q22

Similar to the previous quarter, the majority of top-performing funds are of either the USD or USD-hedged share class. This came on the back of a stronger USD in 3Q22, which appreciated approximately 2% against the SGD and around 6% against a basket of leading global currencies (as gauged by the Bloomberg Dollar Spot Index).

The top performer was the PIMCO Diversified Income Duration Hedged Fund Cl E Acc USD, whose portfolio has a duration of near zero. A key takeaway from this is the importance of maintaining a limited duration exposure.

As a matter of fact, short duration and money market bond funds also graced their presence amongst our top performers. The rising rate environment bestows short duration and money market bond funds with the ability to reinvest into higher-yielding bonds and provide investors with the potential for higher total returns over time, even if near-term market volatility persists. To top things off, short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration and credit risk.

Besides the aforementioned funds, we see funds invested in senior loans among the top performers. One of them is the Franklin Floating Rate A (dis) USD – it primarily invests in floating rate or variable rate senior secured corporate loans or senior secured debt securities. While senior loans may seem enticing due to their floating-rate feature that hedges against rising interest rates, we would like to point investors towards some inherent risks of investing within this bond segment.

Senior loans tend to have a higher credit risk as compared to high-yield bonds. Take for instance the US senior loan market, which has an average credit quality of B+. That is two notches lower than the US high yield’s average credit quality of BB. Besides, the floating-rate nature of the loans means greater debt servicing burdens for bond issuers in today’s rising rate environment, potentially raising credit and default risks and hence paving way for a widening in spreads.

Table 2: Returns of top performing fixed income funds

Bottom Performing Fixed Income Funds of 3Q22

Shifting gears over to the bottom performing funds of 3Q22, it is worth noting that their share classes are in currencies that did not perform well. Currency markets have been rocked hard during the quarter. Against both the USD and SGD, the NZD tumbled to their lowest since March 2020 due to a weakening global risk sentiment while the GBP saw a sharp decline after controversial tax cut plans (which the UK government has since reversed).

Nonetheless, for certain funds, currency movements were not the only explanation for their underperformance. They include the Eastspring Investments - Asian High Yield Bond ANDM NZD-H, Allianz Dynamic Asian High Yield Bond Cl AMg DIS H2-GBP, and Fidelity Asian High Yield A-RMB (hedged). In base currency terms (i.e. USD), the funds delivered losses of -7.18%, -7.57%, and -7.05% respectively, which is much wider as compared to their peers. We reckon that credit selection was a key detractor of their performances.

Meanwhile, inflation-linked bond funds experienced an abysmal quarter. In wake of another 75 basis points hike from the Fed to fight inflation, the demand for inflation protection is falling. The market is expecting inflation to come down, with the 10-year breakeven inflation rate (or implied inflation rate) at just over 2%. Interestingly, we see reasons for decades of low inflation coming to an end. The world is moving into a new regime where structural forces such as higher commodity prices, labour shortage, and the threat of deglobalisation will lead to a more persistent rise in inflation in the years ahead.

(Related article: Low inflation is gone for good. Here’s how to position for a new era of higher inflation.)

Table 3: Returns of bottom performing fixed income funds

Final thoughts

We remain cautious of the economic outlook ahead. Inflation has proven to be sticky, and the US Federal Reserve has made it clear that it will follow through with aggressive rate hikes, even if it means inflicting pain on the economy.

On a more positive note, the valuations of bonds have turned more attractive after the sharp sell-off this year. While not all risks (such as the probability of a recession) have been reflected in valuations yet, global bond issuers generally have sound credit fundamentals and hence are in a good shape to weather the uncertainties. Our preference is for global investment grade, short duration bonds.

(Related article: Looking for yields amidst market volatility? It’s time to revisit this asset class.)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.