Investment grade bond indices are made-up of more BBB issues than in the past, according to Rathbone’s Noelle Cazalis, who says there is a risk that indices are being pumped with lower quality paper.
Cazalis, manager of the Rathbone High Quality Bond fund which launched at the end of 2018, said the BBB universe has more than doubled in the US and tripled in Europe since 2010.
This has meant that investable fixed income universe has seen a surge in lower-quality bonds and contributed to a deterioration in quality of some indices, a potentially troubling issue for passive bond funds. 
However, Cazalis (pictured) – who is also a co-manager on the Rathbone Ethical Bond and Rathbone Strategic Bond fund along with head of fixed income Bryn Jones– said the increase of BBB rated bonds in the index is not reflected in the fund, with just over five per cent allocated to BBBs and BBB+ combined.
“As far as I know, we're the only ones to constrain ourselves on credit quality [in the Rathbone High Quality Bond fund],” said the manager.
“Effectively, we can only have a maximum of 20 per cent allocation to BBBs in the fund, which is the riskier part of the investment grades universe and that's written into the portfolio so it's in place at all times.
“It's not something that’s at our discretion and right now we're de-risking.
“It helps the investor to know that there's not going to be a drift down in terms of credit quality because if you think about the investment-grade universe, the BBB part of the market has grown a lot.”
Nevertheless, should the Rathbones manager see more value in the short-dated BBB space, she would move closer towards her 20 per cent limit for the fund.
Currently, though, the spreads are not that compelling, she explained.
“Looking at both a BBB bond or a single A bond you get pretty much the same spread because it’s so narrow,” said Cazalis.
“It doesn't mean that was always the case, this is on average, but on quite a few cases actually you don't really pick up any yield or any spread by going into a BBB rated holding, so I may as well stick to single A in that case within this fund.”
From research carried out by the Rathbones team they found that some peer funds have up to 57 per cent allocation to BBB but taking on that risk has not helped their yields.
Selecting more single A-rated bonds for the same yield as a BBB bond, Cazalis explained, can help fixed income investors de-risk more effectively.
However, the Rathbone High Quality Bond fund manager noted that often when investors focus on limiting credit risk, they open themselves up to duration risk.
“If they want to de-risk the duration risk, they are then pushed towards short-dated corporate bond funds,” Cazalis said. “But again, you have more credit risk.”
To overcome this, Cazalis explained, the fund is set up as a “hybrid,” to deal with the twin risks.
The launch of the strategy was especially, said Cazalis, given the recent inversion of the UK yield curve.
The impact of this inversion has been a significant shortening of duration on bonds at the moment, according to Cazalis, now down to just 1.8 years.
“It's very short. It's actually shorter than I thought it would be when we launched this fund and it's because of that inversion.”
Taking that into account Cazalis said that it made even less sense to take on both credit risk and duration risk when yields are dropping.
“Effectively today you can buy a six-month bond or a one-year bond, you get the same yield that you get on a 10-year gilt,” she said. “So, most of the opportunity set that we have found is at the shorter end of the curve.”
“I think because economic data has been pretty weak investors are worried about taking credit risk. And you've actually seen over the last few months higher credit rating securities outperforming even riskier names.
“So, I guess that's showing that that shift to more defensive strategies is happening to some extent,” added Cazalis.
The Rathbone High Quality Bond fund has a capital preservation focus investing 80 per cent of the portfolio in A-rated bonds or higher within G10 countries.
Like other funds in the Rathbones fixed income range, the strategy employs a ‘Four Cs Plus’ principles to build a portfolio, focusing on character, capacity, collateral and covenants, with the ‘Plus’ representing conviction to achieve above-average long-term performance.
Performance of fund vs sector since launch
Source: FE Analytics
The fund was launched in November last year during which time it has returned of 3.09 per cent underperforming the average IA Sterling Corporate Bond peer’s 8.94 per cent gain.
The fund has a yield of 3 per cent and an ongoing charges figure (OCF) of 0.35 per cent.