Corporate bonds: discovering hidden potential in the mundane

As with any investment, your or your clients’ capital is at risk. Any income is not guaranteed and can fall as well as rise.

To many, investment grade corporate bonds may seem dull. And so they should! They are typically issued by blue-chip companies with high levels of credit worthiness. Default risk is extremely low. Investment grade bonds can be relied on to offer steady income and add stability to portfolios. So far, so boring.

However, for bond geeks like us, there is plenty to get excited about. The Baillie Gifford Investment Grade Bond Fund has outperformed its target benchmark (index plus 0.75%) by 1.3% in the past 12 months. There is a rich universe of opportunities if you know where to look.

Patience and conviction

The Fund holds bonds issued by 50 to 90 individual companies. This is around a fifth of the issuers in our benchmark index, and far fewer than most of our peers. We can select from a universe of thousands – predominantly bonds issued in sterling but also in euros and dollars, giving us a truly global opportunity set.  This translates into average holding sizes which are greater than is typical and, where we have high conviction, we are prepared to skew the portfolio towards those ideas. 

The foundation of our approach is our fundamental research for which Baillie Gifford is world renowned. Our team of corporate bond specialists spend their time carrying out detailed analysis of a relatively small number of companies to identify potential winners.

Often, we have a different lens to many market participants. We are able to take a patient approach, in contrast to the short-sighted majority. The core of our portfolio is constructed of resilient companies which we are prepared to hold for several years, with a view that in aggregate they will steadily outperform their peers. Usually this comes from incremental levels of income or excess yield, where we believe the market has mispriced the true risks.

In addition to that resilient core of bonds we seek opportunities for capital gains – we aim to spot outsized winners through differentiated research and analysis.

Annington Finance is a recent example that perfectly highlights how investing with patience and conviction can add material value for clients.

The power of transformational events

The word transformational is not typically associated with corporate bond investing.  But as we said, bonds are not always as dull as they seem.

Annington: excess return

In 1996, Annington purchased a 999-year lease on the Married Quarters Estate from the UK Ministry of Defence (MoD). As part of the deal, the MoD leased back these properties and agreed to meet the cost of renovations. Our interest in this company changed in late January 2022 when the MoD confirmed that it was exploring its right to buy back the Married Quarters Estate. The market focused on the short-term risk that the MoD could force a sale at a price that might lead bondholders to suffer losses. We focused on the long-term investment potential. Bond prices already reflected the worst-case outcome.

Our analysis suggested a deal would be reached and, in most scenarios, that would be a good thing for bondholders. We decided to purchase the bonds and wait.

Fast-forward almost three years, and the UK government agreed to pay almost £6bn for the Estate in December 2024, ending one of the most controversial privatisation deals in British history.

The chart above shows the impact on Annington bonds.  Anything but dull!

Close to 3% of the Fund was held in Annington. As one of our highest conviction ideas we ensured significant value was added from our differentiated insights.

The challenge with identifying these opportunities is that analysing their potential for success is hard, they are few and far between, and the timeline over which they might play out can be drawn out and uncertain. We believe our unique approach is suited to overcoming these challenges as we seek to add value for our clients.

Flexible and opportunistic

While always on the lookout for cases like Annington, in an asset class where fundamental credit risks are relatively low, most value from active management is derived from identifying valuation opportunities.

These could be based on a long-term view against the market – bond prices reflect a different trajectory than our research has highlighted. Other opportunities are short-lived, perhaps due to a change in the economic environment or investor sentiment towards certain sectors. Our flexible approach seeks to capture value from both.

The UK water sector provides a good example of this in practice. Issues with Thames Water were well publicised throughout 2024. Our research highlighted many of the problems early on and we quite rightly avoided lending to it, despite it being a material component of our benchmark index. At the same time all water companies were subject to a 5-year regulatory review and negative sentiment towards the sector led to compelling valuations. Our infrastructure experts identified which companies we could confidently lend to, including Anglian Water and South West Water, so the Fund benefited from the bounce back that followed.

Another fruitful source of opportunities in the past year has been the new issue market – companies refinancing their debts with new bonds, or in some cases new entrants to the bond market. The supply of bonds was high during 2024 giving us access to lots of new ideas.

Newly issued bonds are typically offered at prices below those in the secondary market but those valuation opportunities may not last long. Prysmian, an Italian cable company, is one example we sold soon after purchase as prices rose quickly. In other cases, we are happy to be patient. Pearson, a leading company in educational services, is still held in the portfolio – it has performed well but we believe there is further potential.

A clear value proposition

Whatever conclusion you draw, we hope you are reassured that it pays to know your bond managers can find excitement in a “dull and boring” asset class. 

We are confident that our patient and flexible approach will continue to deliver value for clients in the years ahead. We are prepared to stand apart from the crowd. Our focus on deep research and differentiated insights into a small number of companies sets us apart and builds upon the foundations of our cultural strengths at Baillie Gifford.

Past performance

Annual Past Performance to 31 March Each Year (%)

Source: FE, Revolution, ICE Data Indices. Total return net of charges, in sterling. Class B Inc. Share class returns calculated using 10am prices, while the Index is calculated close-to-close.

*ICE BofA sterling Non-Gilt Index

**ICE BofA sterling Non-Gilt Index plus +0.50% to 16 September 2022; thereafter ICE BofA sterling Non-Gilt Index plus +0.75% per annum, over rolling three-year periods. The indices have been chain-linked for performance figures above.

***IA £ Corporate Bond Sector

The manager believes this is an appropriate target given the investment policy of the Fund and the approach taken by the manager when investing. In addition, the manager believes an appropriate performance comparison for this Fund is the Investment Association Sterling Corporate Bond Sector. There is no guarantee that this objective will be achieved over any time period and actual investment returns may differ from this objective, particularly over shorter time periods.

 Past performance is not a guide to future returns.

Important information and risk warnings

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in April 2025 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication contains information on investments which does not constitute independent research.

The Fund's share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.

Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

The images used in this communication are for illustrative purposes only.