Should fund investors go active in global credit?

Global investment-grade corporate credit funds are dominated by active management. Based on Morningstar data as of March 2024, there are 221 distinct European and cross-border-domiciled global credit funds with a combined £118 billion in assets. Actively managed strategies make up 87% of funds and 72% of assets in the universe. Global credit has also shown reasonable survival rates for funds, with 69% of active funds that were around a decade ago still standing today.

That said, recent fund flows over the trailing one, three and five years to March 2024 show that the popularity of index funds is growing. Net inflows over those periods are split pretty much evenly between active and index funds for global credit. It’s therefore worth revisiting how much value active funds in this space have added for investors.

Gross returns show promise

On a gross return basis, there is certainly alpha on offer. The median excess gross return for active sterling-hedged global credit funds over the Bloomberg Global Aggregate Corporate benchmark was 30-50 basis points (bps) annualised over the trailing three, five and 10 years to March 2024. The outperformance rate, which we define as the percentage of distinct active funds that survived the given period and had a positive excess return, ranged between roughly 60% and 70% over that timeframe.

To put that into context, as shown below, the median gross excess return on offer in global credit lies somewhere between that of sterling government bond funds at 10-30bps annualised and global high yield funds at 30-150bps annualised over their respective benchmarks.

Surprisingly, the alpha and outperformance rates are better for global credit funds than high yield funds over the trailing 10 years, although that is partly driven by notably poor returns for high yield funds in 2016, when many missed the rebound in energy.

Net returns struggle on average, but indexing is challenging too

However, seeing as the average ongoing charge for global credit funds is 65bps, can active funds beat the index net of fees over time?

Excluding fund share classes under 25bps, which are likely to be unavailable to most investors, the median excess net return for active sterling-hedged global credit funds has hovered close to zero over the trailing three, five and 10 years (see the chart below). Still, 20-40% of distinct funds have shown a positive excess net return over those periods, which indicates that if you can pick the right fund, active management still pays.

Those results are, however, better when you compare active funds’ net returns with index funds. Over the trailing five years, the median excess return for active global credit funds over the median return for index funds is 34bps, and active funds’ outperformance rate is 60% (not shown in chart below).

That’s partly driven by the challenges of indexing corporate bonds. Corporates often have multiple issues and there are over 16,000 bonds in the Bloomberg Global Aggregate Corporate Index, requiring a sampling approach for indexing. That said, it is worth analysing the process adopted by an index fund as there are a variety of different approaches to sampling and replication, and some funds apply enhanced indexing. Against some corporate credit indices, some index funds have been able to keep up with or modestly outperform the benchmark.

Adjusting for credit risk, only a fifth of active funds have delivered long term

It’s also worth assessing the impact of active funds in this space taking on more credit risk than the index. The median active global corporate sterling-hedged bond fund currently carries 6% more than the benchmark in BBBs, the lowest rung of investment grade, and 5% more in BBs, the highest rung of high yield. So, how much of any outperformance is due an overweight to credit risk?

We test this by comparing active funds’ net returns to a blended benchmark comprising 90% in global investment-grade corporates, 5% in global BBB corporates and 5% in global high yield corporates.

Unsurprisingly, the median excess net return for active sterling-hedged global credit funds struggles to outpace this blended benchmark and it does lower outperformance rates relative to the investment-grade only index.

However, combining index funds won’t replicate the blended index returns given the challenges of indexing, and there are still 37% and 19% of global credit funds that have demonstrated outperformance relative to this higher hurdle over the trailing five and 10 years, respectively. It’s worth noting, though, that while the margin of outperformance for successful managers has been an average of 71bps annualised over five years, it was just 12bps over 10 years. Drivers of that outperformance can include decisions on duration, curve, industry sector and security selection (including the new issue premium, a modest increase in yield typically offered to investors participating in primary issues).

All in all, we believe active managers can still offer value in global credit, but investors should be cognisant that only around a fifth of active funds in this space have survived and demonstrated outperformance over the last 10 years when accounting for the extra credit risk they typically take on.

As such, investors will need to consider whether they have the fund research capabilities to find a manager who can beat most of the pack.