Morgan Stanley Sterling Corporate Bond: August 2022 fund update

• Richard Ford is an experienced corporate bond investor and has the support of a strong team at Morgan Stanley
• The managers mainly invest in higher quality bonds, believing that this will drive superior long term returns
• The fund has performed well over the long term, delivering good returns to patient investors
• The fund is on our Wealth Shortlist of funds chosen by our analysts for their long term performance potential

How it fits in a portfolio

The managers focus on income but aim to generate some growth over the long term too by investing in a wide selection of high-quality corporate bonds. The fund is run in a more conservative way than some corporate bond funds, and could add some balance to a portfolio focused on shares or higher risk bond funds. This means it could perform a little better when bond markets fall, but also lag behind when they rise rapidly.

Manager

The fund is managed by Richard Ford and Dipen Patel who are supported by a strong fixed income team at Morgan Stanley from across the globe. Ford became manager of the fund in 2005 and was joined by Patel as co-manager in 2018. The managers also run a number of other fixed income strategies at Morgan Stanley, but we think the duo have the experience, support and resources to do a good job for investors.

Process

The managers start by forming their outlook for the wider global economy, considering the prospects for growth, interest rates, inflation and more. They then research individual companies and bonds, trying to make sure companies have the ability to pay the full interest on their bonds and make the capital repayments too.

They think superior long-term returns will be generated by holding better quality bonds. Although they could provide a lower return than higher-risk ones when the economy's doing well, they feel these higher-quality bonds will more than make up for it by falling less when bond markets fall. Ford and Patel also take account of valuations to avoid bonds that could be too expensive, or where the yield is too low to offset the risks they've identified.

The fund invests heavily in the UK, but includes some global bonds too. Where they invest in overseas bonds, the managers remove the effect of currency exchange rate changes by using derivatives, which can add risk. They also have the freedom to invest in high yield bonds which also adds risk. They never invest more than 20% of the fund in these types of bonds.

The managers believe that the companies they invest in are generally well placed to perform strongly in future as they have entered this challenging economic environment cautiously and so have plenty of cash and resources that will help if there is a recession. They do not believe that inflation will remain high for years to come but this is more of a risk than previously.

The manager has reduced the funds’ underweight duration position in 2022, bringing it into line with the index. Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. The managers used to have a lower duration position, which did well for them as interest rates have risen during 2022 so far. But following the interest rate rises in 2022, the managers prefer credit risk instead of interest rate risk at the moment.

The fund currently has 9% of its assets invested in high yield bonds. These are bonds that offer a higher income to investors, but are issued by companies that have a greater risk of not paying their debts. The managers trimmed their investments in high yield bonds earlier this year because they had performed well compared to other bonds. They used the proceeds to top up their investments in investment grade bonds (those with a credit rating of BBB or higher) because they have fallen more in value and are now looking attractively priced.

Going forward, the team are concerned by inflation and whether the UK will fall into recession. A recession would increase the potential for companies to default on their debts. But the manager does not think a big recession is likely and if this is the case, bonds are currently offering longer-term investors the change to make money.

Culture

Morgan Stanley’s scale and strong history of managing clients’ money means Ford and Patel can rely on an extensive team of experienced bond investors to help them find the best investment opportunities. We view it positively that the managers are incentivised to focus on long-term performance.

The managers are rewarded through a share of the revenues their fund generates. We think their incentivisation structure is better than at some groups, though would prefer a more explicit link to the fund’s performance.

ESG Integration

The managers of the fund consider ESG factors, believing that they can impact the price and risk of a bond and that responsible companies tend to have fewer defaults. This includes assessing the momentum and direction of a company’s performance on ESG metrics to gauge if it’s improving or declining in these areas. However, the managers are clear that the return profile of the bond is more important than whether it rates highly from an ESG perspective.

Morgan Stanley’s approach to ESG is led by a group of specialists from across the company. As a business they believe well-managed companies are more likely to produce long-term, sustainable returns. The business encourages investment teams to adopt ESG approaches that most appropriately integrate with their strategies, but also promotes a set of shared principles to guide their collective ESG effort. This means there’s a consistent approach to how ESG issues are assessed across the business, but fund managers do have some autonomy around how it’s integrated into their analysis. Fund managers also benefit from the support of the Global Stewardship team.

Cost

The fund has an annual ongoing fund charge of 0.37%, but through Hargreaves Lansdown you can secure an ongoing saving of 0.15%. This means you’ll pay an ongoing charge of 0.22%. We think this is great value. The HL platform fee of up to 0.45% a year also applies.

Performance

The fund's relatively defensive approach means it has tended to perform broadly in line with a rising market and provides some shelter during tougher periods. The fund has done well for investors who've patiently stayed invested over the long-term. But past performance is not a guide to the future.

Over the 12 months to the end of July 2022 the fund delivered a return of -12.28%* to investors, underperforming its peer group average by -0.82%. It has been a very challenging period for bond investors with high inflation and interest rate rises causing bonds to fall in value. Many of the fund’s investments in corporate bonds lost money. In particular, investments in the bonds of banks and companies in the wider financials sector detracted from performance. Holding fewer bonds in the Capital Goods and Utilities sectors added to benchmark-relative performance.

The fund had a lower duration position for much of this period which aided performance in this tough environment. Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. So, a lower duration position means the managers tried to decrease the fund’s sensitivity to rising interest rates to protect the fund from losing as much money as interest rates rose.

We continue to believe Richard Ford and Dipen Patel have the potential to reward long-term, patient investors. Remember though that all investments fall as well as rise in value, so investors could get back less than they invest.

Past performance is not a guide to the future Source: *Lipper IM to 31/07/2022.

Find out more about Morgan Stanley Sterling Corporate Bond, including charges

See Morgan Stanley Sterling Corporate Bond Key Investor Information