Interest rates are on the way down in the UK.
That is traditionally good news for bond funds. But for passive corporate bond funds it is not necessarily good news. I am bound to argue trackers are crackers when it comes to bonds but hear me out and I hope you’ll agree.
First, a bit of market context. Trump appears to be backpedalling a bit on tariffs but the repercussions continue. Growth, globally, will suffer.
That said, we are starting from a place where unemployment is very low, wage growth is healthy, the savings rate in the UK for example is very high and corporate leverage is low.
We also know slower growth will bring rate cuts which will be supportive of markets. We saw the latest in the UK last week.
The markets already know weak economic data will start to appear at the end of May and into June — a known known — but the extent of the economic damage remains a known unknown.
In boxing, they say it is the punch you do not see coming that knocks you out. But we think the worst of the damage is done already.
The markets will be volatile as we lurch from economic headline to economic headline. But we know these punches are coming and we are not expecting the market to fall over.
When things are so uncertain — and interest rates appear to be heading down — you usually want to have lots of interest rate risk or be long duration in bond market parlance. However, in the Artemis Corporate Bond fund, we are meaningfully underweight to long-dated bonds.
Importantly, even that exposure is concentrated around the 15-20-year zone with nothing beyond 30 years to maturity. The combination adds up to a very meaningful underweight to long-dated bonds.
This leaves the fund with a modified duration of approximately 5.5 years compared to the index of approximately 5.75 years.
This is not what the textbooks tell us to do when interest rates have fallen (and the Bank of England base rate is predicted to fall from 4.25 per cent today to approximately 3.5 per cent by year end).
So why go short? Yes, the weakness in economic data that will come through will meaningfully increase the pressure for central banks to cut base rates. But lower economic growth will require higher borrowing levels, pressuring longer-dated bonds with increased supply and occasional concerns about debt sustainability.
So while we expect the bond markets to be largely rangebound for the rest of the year, the pressure remains for steeper yield curves.
This means while the BoE base rate falls, shorter-dated bonds will benefit, but longer-dated bonds will not enjoy the full benefit, as you would traditionally expect.
But before we get too panicked about government bonds, and gilts in particular, there are things that can be done.
The UK has the luxury of having issued vast amounts of very long-dated government bonds and has locked in very low coupons for a very long time.
The UK has a much longer average maturity of its debt than all other countries, almost twice as long as most other developed countries.
It can very easily tilt issuance to shorter maturities without running into liquidity problems, which it has been doing.
While we expect curves to steepen, we are not expecting things to get out of control. The market will benefit from rate cuts, but that favours shorter maturities more than longer maturities and hence we will retain our curve steepening position for the foreseeable future.
Index exposure could be painful
If our view on markets is right, index-tracking corporate bond funds face a challenge. They obviously cannot pivot their positioning.
They are locked in to a full weighting of long-dated bonds, whether that is a good idea or not. They cannot put on the curve steepener.
There are a few other things they cannot do either. Most companies issue many bonds, often in sterling, dollars and euros, some shorter dated and some longer dated.
Active funds can cherry pick the bonds with the most value, and ignore the expensive ones, something passives obviously cannot do.
They focus on the largest bonds in the market. It means when there is anxiety in the market and people want their money, all these passive funds are selling the same bonds at the same time.
This creates interesting opportunities for the nimble to pick up oversold bonds cheaply.
Further down the credit spectrum, the mispricing opportunities created by passive trading become even greater. In the high-yield market, the index is more heavily weighted towards the companies with the most debt in issuance.
It is the equivalent of equity indices having greatest exposure to the companies with the biggest market cap. The difference, though, is companies that borrow a lot are not necessarily the ones you want to have exposure to!
I could go on. But how does this pan out in the numbers?
Over the past five years, trackers rallied less in up markets and fell more in down markets relative to their actively managed brethren — the difference in returns in the investment grade arena is 5.5 per cent — and that is mapping trackers against only average bond funds.
Stephen Snowden is head of fixed income at Artemis