The quality of the portfolio manager is decisive for a bond fund

Stocks are now close to all-time highs, credit spreads are at their lowest, and there is now little return on this risk. “It is still true that bonds are interesting for investors even this year, but it is always necessary to carefully study the information on bond funds and know what type of fund it is and how its portfolio manager works with it. Today there is room for active portfolio managers,” says Leoš Jirman, partner and CIO of the EMUN investment company, in an interview about this year’s situation on the bond markets.

What has been the situation on the bond market so far and how do you see it going forward?

In the case of the Czech bond market last year, as the Czech National Bank (ČNB) began to lower rates, bond prices rose and interesting returns were achieved. Last year it was 12 percent on Czech government bonds alone. I don’t think that will happen again this year, because we are already close to the equilibrium level of long-term returns. Government bonds will still rise with a drop in CNB rates, but not as much. There is still an interesting investment opportunity out there that may be better than interest on term deposits, but the easy money has already been made for us in this asset class this cycle.

And how is it across the ocean?

Thanks to the fact that the decline in rates has not yet started in America, bonds there now have very interesting yields. But the problem is that bonds also carry credit risk, and corporate bond credit spreads are very low there now, and an investor has to be careful what bond they buy.

Advantages of mixed funds

How are bond funds mixed these days?

On the Czech market, you can buy Czech government bond funds, corporate bond funds and bond funds with a low investment rating or a mix, i.e. those that are mixed. You must therefore always analyze what you are going to invest in and you need to know that performance will develop differently for each type of fund in the future.

Is it advantageous to have a fund mixed not only with Czech but also with foreign bonds?

A mixed fund can be interesting, among other things, because it can equalize the situation between individual countries. For example, Czech government bonds have already reached a significant part of their potential in this cycle, but in the US the rate cut has not even started yet. However, whether it is an active or passive fund also plays a big role in investing in funds.

And what is the difference between an active fund and a passive one?

If you have a passive fund of Czech government bonds, which, for example, keeps the maturity of the bonds similar for the entire period of existence, then you know how much you can still earn in the event of an expected drop in rates. Whereas if you have a portfolio manager of an active fund that can switch between government and corporate bonds and can take advantage of market declines and price increases, its performance can be significantly different. I think that there is currently room for active portfolio managers. There will be hard work where a skilled active portfolio manager can really stand out from other portfolio managers and earn clients much more. In the current market conditions, the quality of the portfolio manager will matter more than ever.

An active portfolio manager can invest not only in different segments of the bond market, but also in different regions and currencies. I would now recommend the ones that are more mixed because they are more diversified and you can achieve higher returns with them. It is also always necessary to look at what role the bond or bond fund plays in the investor’s portfolio. If it is supposed to be a substitute for a term deposit, then a government bond fund with low sensitivity to changes in interest rates is probably the best. If it is to be a longer-term investment and it is only part of the overall portfolio, it is possible to go for more dynamic or riskier options. And even in the Czech Republic, there are bond funds that have a mix of different categories of bonds, including foreign ones. In our EMUN Fixed Income fund, for example, we have a mixture of Europe, America and the Czech Republic, and we invest in state and corporate bonds as well as bonds with a lower rating.

What is good to know about private credit

You also talked about the decline in risk premiums. Does it apply everywhere?

Yes, risk premiums are already very low for bonds, whether in Europe or the US. However, it has not yet reached the segment of private credit (sometimes also called private debt, editor’s note), i.e. privately negotiated debts. There, it is a one-on-one negotiation, and there, as a fund manager, I directly negotiate terms with a specific company, including the interest rate or collateral, and I do not have to strictly follow the rates that are on the bank loan market. It is about negotiation, about demand, about the company’s ability to borrow from the bank. The decline in risk premiums has therefore not yet fully reached there, which is why it is a segment where there is still potential. As a relatively small investor, I cannot negotiate with a specific company, but the manager of a large private credit fund, who negotiates the conditions under which the fund will grant a loan to the given company. Such debt is not even publicly traded.

And where can I buy this type of investment as a retail investor?

You have to find a private credit fund directly, which contains mixed debts of different companies. And there are a lot of those companies to make it diversified. However, most of the time, even investing in this fund is not for a retail investor, but it is a fund of qualified investors with a relatively high minimum investment. We also buy funds investing in private credit into our fund. We currently have about 20 percent of our fund in this asset class. In this category of debt, we focus mainly on the selection of a quality fund and therefore work only with the largest and best global managers.

Bond investments this year

So is it even worth investing in bonds this year?

It is definitely worth investing in bonds. It’s an interesting asset class, and even after the drop in yields last year, options in bonds are still attractive compared to previous years after the great financial crisis of 2008/2009. But as I said before, you need to be selective and always familiarize yourself with the fund’s investment strategy and conditions before investing.

And how do I know the right fund in which it makes sense to invest?

I always have to look at the articles of association and read everything about the fund. It depends on what I’m looking for. For example, if I’m looking for an active portfolio manager, I have to look at how the portfolio changes over time, how it reacts to changing market conditions. I have to judge that it is not a “buy and hold” style, that I buy once and hold until maturity. For example, the yield on the Czech government bond fell to 3.8 percent this year and then rose again to 4.6 percent. The yield percentage for a 10-year government bond is then already 6 to 7 percent on the price, and it is thus possible to make interesting yields by actively trading a part of the portfolio.

Can a retail client buy the bonds themselves?

Market-traded bonds are mostly traded in large volumes and access for the small investor is limited. If a stockbroker already mediates the purchase of individual bonds for smaller clients, it is necessary to calculate that there is always a relatively larger spread (i.e. the difference between the purchase and sale price of a financial instrument, editor’s note), because the volumes of retail investors are small and of course there is also a trade fee. However, when the fund buys bonds, it does not buy in hundreds of thousands, but in tens of millions of crowns, and the spreads are significantly smaller. In addition, even a million crowns is not enough for a small investor, because he will buy, for example, only one issue of bonds, and even in this class of assets there is a need to significantly diversify. For small investors, it makes sense to invest in bonds, especially through funds, which also has its own tax advantages, such as a three-year tax test (exemption from sales tax after more than three years, editor’s note)

What are the risks of investing in bonds this year?

The risk is if interest rates stop falling and instead turn around and start rising. This could theoretically happen in the USA, it will most likely not happen in the Czech Republic. When rates rise, bond prices fall, as we witnessed in the period 2021 to 2022, when Czech government bonds fell by almost 25 percent, CNB rates rose from almost zero to 7 percent in this period. No one expects such growth in the near future. When investing in US bonds then we have to expect more volatility because it is not clear when exactly the rate cut will happen. Which is again an opportunity for active portfolio managers.

However, in general, there are always two risks to keep in mind when investing in bonds. For one thing, when interest rates rise, bond prices fall, when interest rates fall, bond prices rise. The second risk is credit risk. This is the risk of whether the issuer will actually repay the bond at the end. When credit spreads fall, bond prices rise and vice versa. Credit spreads on bonds are currently already very low and the excess return you get for credit risk is already very small. When the economic situation worsens, credit spreads widen, and this has the same effect as if rates were rising. If the credit spread of some bonds is now 2 percent, it means that I am buying a corporate bond with a yield 2 percentage points higher against a similar government bond. However, during an economic crisis, the credit surcharge can be many times higher, for example close to 10 percent, and this in turn must be reflected in the price of the bonds so that the price of the bond drops significantly.

Who is Leoš Jirman?

Partner and chairman of the board of directors of EMUN investiční společnost, as, is a graduate of Charles University’s MFF. His career in the capital market began in 1992 at Investiční banka and continued at BH Securities, where he worked his way up from a Czech capital market analyst to a portfolio manager focusing on foreign markets. With experience in trading on the capital markets and as an analyst at CNB, Leoš brings to EMUN expertise in the field of the functioning of financial markets and investing.

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