The sharp decline of stocks in late 2018, followed by a strong surge at the beginning of 2019, has made for exciting investment watching. But more quietly, corporate bonds have seen some dramatic moves as well.

Late last year, investors sought to reduce risk by sprucing up the quality of their fixed-income portfolios. The move to securities rated “A” or better widened the spread in yield between the highest-rated corners of the corporate bond market and those with less-stellar credentials to levels not seen for several years.

As fears of inflation, trade disputes and interest rate hikes wore off, the selloff in late 2018 turned into a rally for credit markets at the beginning of this year, particularly among bonds with non-top-tier ratings. Investment-grade markets returned roughly mid-single digits in the first quarter alone. High yield did even better.

The $4.1 billion MFS Corporate Bond Fund benefited as investors decided to take a more “risk-on” stance in search of yield and gravitated to “BB” and “BBB” rated issuers, an area where the fund has a long history of being overweight relative to its benchmark, the Bloomberg Barclays U.S. Credit Bond Index. (“BBB” is the lowest investment-grade rating assigned by Standard & Poor’s, while “BB” is the highest non-investment-grade rating.) As of March 31, the MFS fund had nearly 70% of its assets in those two investment categories, with the lion’s share of that in “BBB” securities. Thanks largely to that positioning, the fund’s “I” shares outperformed the Bloomberg index during the first quarter of 2019, returning 5.60% while the index returned 4.87%.

But the big nod to mid-tier credits means the MFS fund may lag during less certain times when investors tend to seek out higher-rated securities in search of safety. That happened in 2018 when the fund’s performance fell behind that of two-thirds of its Morningstar peers. Nonetheless, the fund has generated strong returns over longer-term periods, with volatility similar to that of its benchmark.

That “up and comer” niche of the bond market has long been a favorite hunting ground for Robert Persons, who manages the fund with Alexander Mackey. Thirty years ago, when Persons began his career as an investment analyst, he noticed that he sometimes disagreed with the ratings that Moody’s or Standard & Poor’s assigned to some bonds. Many times, his assessment proved to be correct and the bonds were later upgraded.

“While rating agencies do a pretty good job, they often have trouble nailing down the differences between a ‘BB+’ and a ‘BBB-’ credit,” he says. “That difference is important, because when a bond moves from non-investment grade to investment grade, investors react favorably and its price goes up.”

Although the fund is classified as an investment-grade offering, Persons still has a particular fondness for what he views as the rising stars of the bond world whose ratings and valuations do not reflect their true quality. “We like to beat the rating agencies to the punch,” he says.

He looks to take advantage of persistent inefficiencies in the “BB” and “BBB” ratings universe by finding issuers that will likely enjoy capital appreciation with little incremental volatility over the index. Those inefficiencies are created when investors relying too heavily on ratings fail to identify undervalued, high-quality companies. The “BB” bond space is a good hunting ground for undervalued securities because their yields are often too low to attract high-yield investors. “It’s the most inefficient space in the bond market,” he says.

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