Royal London Corporate Bond: March 2024 fund update

• Shalin Shah has over 15 years’ investment experience at Royal London

• The fund has delivered good returns over the long term and the managers benefit from the support of a strong fixed income team at Royal London

• The managers dig a little deeper to find bonds that might be missed by other investors

• This fund features on our Wealth Shortlist of funds chosen by our analysts for their long-term performance potential

How it fits in a portfolio

The Royal London Corporate Bond fund is focussed on investment grade bonds and aims to provide an income alongside some capital growth. We think it’s a more adventurous choice in the space. Because of this, the investment journey may be more volatile than some peers. For this reason, it could work well as part of a portfolio invested for income, focused on the long-term. It could also provide some bond exposure to a portfolio more focussed on company shares.

Manager

Following a change to the management team at the start of February 2023, the fund is co-managed by Shalin Shah and Matthew Franklin. Shah joined the fixed income team at Royal London in 2008 and has been involved in managing the fund since 2016. Franklin joined Royal London’s sterling credit team in 2014 and has co-managed the fund since January 2022.

Previous co-manager, and Head of Fixed Income at Royal London, Jonathan Platt has stepped back from his role as a manager of this fund. He remains in his role as Head of Fixed Income though and will continue to offer support and challenge to Shah and Franklin going forward.

We rate Shah and the bond team at Royal London highly. They're prepared to invest in parts of the bond market a lot of other investors ignore. Looking for opportunities in under-researched areas like unrated bonds can throw up chances to boost returns. That said, this is a higher risk approach and means there’s potential for investments in the fund to be more volatile.

Both managers also have management responsibilities on other funds, but they’re supported by a very well-resourced team, so we feel comfortable they can handle the workload.

Process

Shah and Franklin believe credit markets are inefficient and offer opportunities that active managers can exploit. They start by forming a view on the direction of the economy, considering factors like economic growth, inflation and interest rates. This helps them decide which areas to invest in.

We think the team's edge comes from their detailed research into 'low-profile' parts of the market. Shah and Franklin feed off ideas from the wider fixed interest team but also do their own research to check if the quality of these bonds is high enough to be considered for the fund. These under-researched bonds may be unrated (their credit quality hasn’t been assessed by a credit ratings agency), complex and often secured against a company's assets. The managers can potentially add value by looking in this area of the market, but these types of bonds are higher risk, and the lack of credit rating can make them harder to trade, adding liquidity risk, particularly in a falling market. They tend to pay a higher income to compensate for the higher risk. Around 5% of the fund is currently invested in this area, down from around 7% 12 months ago.

As an example, one of the bonds the managers invested in within this unrated category defaulted in 2023. The company had found it difficult to refinance their debt in time for them to make a payment due on the bond. This meant that they missed the payment and defaulted on the terms of the bond. They were able to refinance shortly after the payment due date and in turn paid the amount due to investors, plus interest. The outcome was that investors didn’t lose any money.

However, it’s rare for bonds that are considered to be investment grade to default on their bond payments. This highlights the higher risk that can be associated with the way that the managers of this fund invest. While on this occasion the issue was resolved relatively quickly, it could be that in similar instances in future, there are bigger challenges facing the company and that refinancing isn’t possible. This could lead to a lengthy process for the managers to go through in order to get their money back.

The fund has a focus on A and BBB rated bonds, which sit at the lower quality end of the investment grade corporate bond spectrum. The fund also invests in higher-risk high-yield bonds, which can add risk. The managers aim to be well diversified through exposure to a range of different sectors.

The managers have continued to look for opportunities in the new issues market – these are bonds newly issued by companies. Recent examples include those of Barclays, Credit Agricole and Places for People.

The managers expect the current levels of inflation to continue to fall however note that wage increases and high food and energy prices remain. They also think that interest rates are likely at their peak but may not be reduced very much in the near term.

Culture

We believe Royal London’s speciality is in managing fixed income portfolios. Their philosophy is that all well-diversified portfolios should include an element of income. They use a combination of top-down macroeconomic analysis and bottom-up security selection to manage their bond portfolios which has served them well over time.

The managers are rewarded based on the long term performance of their fund, so their interests are aligned with investors. We think their incentivisation structure is better than most and encourages good behaviour, but it isn’t as long term as in some other groups.

ESG Integration

The managers consider environmental, social and governance (ESG) factors in their analysis. This helps them identify potential risks that could affect the business’s ability to repay its debts, increase costs or result in future litigation.

All Royal London fund managers have access to ESG ratings and analysis produced by the firm’s central Responsible Investment team. The firm asks that all managers incorporate this into their investment decision making processes, but our meetings with Royal London fund managers suggest the quality of ESG integration from fund to fund is mixed. The firm’s sustainability branded funds fully integrate ESG, with the support of the Responsible Investment team.

The Responsible Investment team coordinates company engagement and engagement case studies can be found in the firm’s annual Stewardship and Responsible Investment report. The firm also publishes a summary of voting activity on its website, and an interface allows visitors to search for all voting activity relating to a specific company, or any time period, and includes a rationale in cases where the team voted against a proposal or abstained.

This is not one of Royal London’s sustainability branded funds though, so the managers may still invest in bonds that could be issued by companies considered to be ESG sinners.

Cost

The fund has a standard annual ongoing charge of 0.56%, but we’ve secured a 0.19% saving for HL clients. That means a net ongoing charge of 0.37%. Our platform charge of up to 0.45% per annum also applies, except in the HL Junior ISA, where no platform fee applies.

Charges can be taken from capital, which can increase the yield but reduces the potential for capital growth.

Performance

The fund’s more adventurous approach to investing in corporate bonds means it’s tended to be more volatile than others in the sector. Over the long term the fund’s generally performed well for those investors who’ve been prepared to ride out the dips. Past performance is not a guide to the future.

The last year has been more positive for bond investors compared to the 18-months that came before it. While earlier in 2023 bonds continued to struggle as interest rates continued to rise to combat inflation, towards the end of the year investor expectations shifted towards the view that rate rises had stopped and rate cuts were on the way. This saw bond markets generally rebound very strongly over the latter part of 2023. So far in 2024, bonds have given back some of those gains, however, over the 12 months to the end of February 2024, bonds have generally provided positive returns.

It's no different for this fund, which has outperformed the IA £ Corporate Bond sector average over that period, returning 8.09%* compared to 5.90%. The industries that contributed most to returns for the fund were insurance and banks. Within those sectors, the managers’ bond selection also added value. At a sector level, there weren’t any significant losses for the fund, which shows that the general market environment was a positive one.

In terms of bond issuers, the best performing bonds held in the fund were from AVIVA and the European Investment Bank. The worst performing issuer was Thames Water, which has been negatively impacted by press reporting around their sewerage management and the quality of water they provide.

Duration is a measure of how sensitive the fund is to interest rate changes, the higher the duration value, the more sensitive the fund is to interest rate changes. The fund doesn’t take large duration positions away from the benchmark, as the managers prefer to focus on bond selection to generate returns. However over the year the managers have altered their duration positioning and this has added some value at the margin. At the end of February 2024, duration positioning was slightly higher than peers.

At the end of January, the fund had a distribution yield of 5.75%, although yields are variable, not guaranteed, and are not a reliable indicator of future income.