Introduction
In a previous blog, we've written at length about the factors that drive equity (stocks) returns
and why it's important to ensure you compare apples to apples when comparing equity fund returns. There are similar challenges when it comes to comparing the performance of bond funds, and as with some equity fund analysis, you will often find comparisons that raise an eyebrow!
This blog will not go into the same detail as the equity blogs, but it will hopefully give the reader sufficient information to undertake their own research and, as always, question everything that they read (including this!).
Factor One: Credit risk
The first factor we will look at is credit risk (sometimes known as default risk). This reflects the chance that the bond issuer might get into difficulties and be unable to pay future coupon payments and/or the principal at maturity. Credit rating agencies assign credit ratings to issuers of bonds, intended to give an idea of the creditworthiness of a bond. However, the credit rating agencies were criticised for their part in the subprime crisis (2007-2010). So, as always, it is prudent to do your own research. The three leading agencies are S&P Global Ratings (S&P), Moody's Ratings and Fitch Ratings.
At a high level, agencies tend to group issuer ratings into either investment grade (high credit quality) or non-investment grade (lower credit quality, sometimes known as high yield or junk). Within these high-level rankings, there are more granular subdivisions.
Anything "lower medium grade" and above (right-hand column below) is considered investment grade; anything below is non-investment grade.
We can see the impact of credit risk by looking at some turbulent historical periods and comparing investment and non-investment grade bonds. For this analysis, we will be using PortfolioVisualizer.
Vanguard's Intermediate-Term Treasury Fund (VFITX) will represent investment-grade bonds (U.S treasuries).
According to Morningstar, this fund has an AAA credit rating (the highest rating - see above) and a duration (more on duration below) of around 5.
We will also be using Vanguard to represent non-investment grade bonds.
Vanguard's high-yield corporate bond fund (VWEHX) has a duration of around 3 and a credit quality of BB-. BB- is in the top tier of non-investment grade, which is enough of a difference from AAA to demonstrate our point.
COVID
Let's start with COVID. We can see that high-yield bonds suffered, having a maximum drawdown (how much the fund fell from peak to trough) of over 10%! Intermediate-terms treasuries were hardly affected, while U.S. equities fell by just over 20%.
Global Financial Crisis
We saw an even more significant disparity during the Global Financial Crisis (GFC). Junk bonds fell by almost 30%. This wasn't as bad as U.S. equities, which fell by more than 50%, but again, intermediate-term treasuries were relatively unimpacted, having a max drawdown of under 4%.
Factor Two: Interest rate risk
Interest rate risk is the potential for a bond price to be impacted due to a change in interest rates. As interest rates rise, bond prices fall, and vice versa. Interest rate risk is measured in duration, and a higher duration means the bond price will be affected more by a given change in interest rates.
For this analysis, we will continue using VFITX to represent intermediate treasuries and use Vanguard's long-term treasury fund to demonstrate the impact of increasing duration.
According to Morningstar, the fund has a duration of around 14.5 and, as with VFITX, has an AAA credit rating.
2022
As covered in another blog, 2022 was a challenging year for bonds, especially those with a longer duration. The Fed raised interest rates 11 times starting in March 2022. As might be expected, the longer the duration, the greater the fall in value
Oranges vs apples
As can be seen from above, challenging market and economic environments can have differing impacts on bonds with varying credit quality and duration, and it's essential to account for this when evaluating bond funds.
For example, comparing the performance of one bond fund that has a shorter duration and lower credit quality than another over the last three years when we've had broadly benign credit conditions and rising interest rates is something that we would question!
About us
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
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