Sunniva Kolostyak: Bond funds, and global flexible bond funds in particular, have had really strong performance in the past year so popularity has soared. But is that something that can keep up in the next year as interest rates are coming down?
To answer this, I’m joined by Mara Dobrescu, our director of fixed income ratings in the manager research team. Mara, thank you very much for being here. Can you explain why these funds have become so popular and why they’ve performed so well?
Key Factors Driving Fixed Income Markets
Mara Dobrescu: Well, fixed income markets last year were really driven by two key themes. First, on the rate side, investors initially anticipated significant rate cuts. And then with the economy being relatively strong, inflation being relatively stubborn, that led central banks to scale back on that monetary easing in the second half of the year. That pushed government yields higher and challenged many managers that were expecting these rate cuts.
Meanwhile, investors risk appetite really catapulted high yield bonds. You have indices like the Morningstar Global High-Yield Bond Index that returned more than 8% on a USD basis, and that was boosted by elevated starting yields and the tightening of spreads. So that’s really the backdrop against which these global flexible bond funds really outperformed the index last year. And it was mainly due to credit exposure, in particular in the higher yielding segments that really drove returns.
Where Did Flexible Bond Funds Find Value in 2024?
Kolostyak: So where have these funds found value?
Dobrescu: So, the first area was investment grade corporates, which many managers overweighted during 2024. In particular, many funds found better valuations in Europe, where they believe there was a higher likelihood for further interest rate cuts. And European credit in general has tended to be cheaper than US credit really since 2022, and that was in part because of geopolitical events, Russia’s invasion of Ukraine and energy supply concerns that affected the continent. That valuation gap between European and US credit narrowed in 2024, but many managers today still think European exposure is more attractive, given better valuations.
And then the second theme was high yield. Though managers tended to avoid the riskiest, the lowest credit runs last year, a very popular trade was subordinate financials. Now these are junior bonds that are issued by high quality banks and insurance companies. And these tend to trade at pretty attractive levels due to their degree of subordination.
And then the third theme that really worked last year was US agency mortgage-backed securities. Many managers thought that agency MBS were particularly cheap after the US Federal Reserve decided to sell agency mortgages from its balance sheet as part of its quantitative tightening efforts. And it definitely paid to own these securities both in 2023 and last year in 2024.
Top Performing Flexible Bond Funds of 2024
Kolostyak: So, can you give some examples of some funds that did well in that year as well? And were there any funds maybe that were left behind?
Dobrescu: Yeah, there’s more than can be mentioned here, but I will single out a couple of examples. Funds like Capital Group Global High Income Opportunities really benefited from a high yield allocation. That’s one had around 4% in high yield in recent years, although the managers emphasized more defensive sectors like financials and pharmaceuticals rather than very cyclical companies. Other funds that had this bias towards corporate credit were BlackRock’s BSF Sustainable Fixed Income Strategies, although that stayed more on the investment grade side. Other funds like Robeco SDG Credit Income also benefited.
On the other hand, the funds that suffered were mostly funds that have kept a very long duration profile. So those were the likes of Janus Henderson Strategic Bond or T. Rowe Price Dynamic Global Bond or Jupiter Strategic Bond.
Where Next for Flexible Bond Funds?
Kolostyak: So, when we move into this next year then, do you think these funds will be able to keep up this momentum as well? Or do you see, maybe, there might be a little bit of a shift?
Dobrescu: Yeah, I’d say that the outlook at this point is relatively cautious. On the rate side, you have stickier than expected inflation in the US, the UK, and that sort of challenging this whole disinflationary narrative. In 2022 you had like relatively coordinated rate hikes across the world. And then in 2024, managers started to anticipate more dispersion in monetary policy across a region. So that’s adding a little bit to the uncertainty.
And then on credit, you have corporate fundamentals that are remaining solid across many sectors, but spreads are much tighter than they have been, and that offers limited upside and significant downside risks in fact, as the economy slows down. So, bargains are not as easy to find, many managers are saying that corporate credit now has a pretty asymmetrical credit profile. So that means there’s limited upside, that’s more downside risk, if the economy slows down.
But the bottom line is that it might be more difficult to generate alpha in the next year. Financials are starting to exhaust a little bit of their potential. Having said that, for investors looking at these funds, it’s really important not to be too absorbed by short term performance and to really stay patient. These global flexible bond funds may occasionally have bouts of spectacular underperformance, for example, if they get caught on the wrong side of a duration trade. But they can also have astounding rebounds over short periods of time and that sort of boom or bust performance pattern, that’s a testament to the flexibility of these products. But it also requires a strong stomach and is best paired with a long-term investment horizon.
Kolostyak: Mara, thank you very much for joining today. For Morningstar, I’m Sunniva Kolostyak.
You can read the full report here: Evaluating Global Flexible Bond Funds.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
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