Exclusions over illusions

An investment process is defined as much by what it refuses to hold as by what it buys. And with high-quality yields at levels not seen in a generation, the things a bond fund rules out cost less to give up than at almost any point in living memory, as David Roberts and Alex Ralph explain. 

Ask a fund manager what they own and you will get a polished answer. Ask what they will never own, and why, and you learn something more useful. For a fund supposed to behave like a bond fund – to provide decent income, hold its value reasonably well when markets wobble and be easy to exit if a client wants their money back – the things it rules out is a key part of the investment process.

It helps that refusals are cheap to make right now. The usual defence of holding riskier securities is that you have to find yield somewhere. That excuse has expired. The yield on some of the assets we hold are at thirty-year highs and we are not talking about anything exotic. Today, you don’t need to take heroic risks to find yield. 

Exclusions over illusions

So, what won’t we own? We will not own the lowest-rated high yield. CCCs and below behave less like traditional bonds and more like leveraged equity. In 2025, the default rate for CCCs was 25.9%, against 1.18% for single-B credits and just 0.08% for BBs.1 That is not a smooth gradient. It is a cliff edge, and that is never a comfortable place to be.

The refinancing arithmetic sharpens the point: more than $60 billion of CCC and C-rated high yield matures this year, more than double the single-B figure, much of it already trading well below par.2 Whether those borrowers can refinance depends on where yields sit (currently close to 14%) and whether anyone fancies buying – a dependency most bond investors can do without.

We will not own additional tier 1 bank debt. Widely held and exchange-listed, it ranks alongside equity in the capital structure. But think about that for second. In times of genuine stress, if the equity is worthless, so is the AT1. March offered a timely reminder. When the Italian lender BFF Bank had its dividend suspended over accounting concerns, its shares fell 55% in a day and the price of its AT1 bonds dropped from 94 to 75.3 

Then there are exposures that do not announce themselves as risk at all. We hedge currencies back to base, because unhedged FX is a zero-sum game in which banks win and fund managers don’t. Over time, currency moves can have a huge impact on underlying bond returns. It’s another source of volatility investors neither expect nor want. 

We will not own private or illiquid securities, because our fund is priced daily and valued externally. A client who hands over cash today is entitled to take it back tomorrow, and an asset that cannot be sold or fairly marked breaks that promise. 

We also keep unhedged local-currency emerging market debt out of the portfolio. It is less liquid, more volatile and essentially a tourist market where holdings that look like diversifiers can turn out to be far more correlated than investors realise.

Why we changed our minds

At this point, a quick confession is in order. In previous roles before starting up Palomar, we held some of these instruments. Not in size – we were light-touch users of CCCs and AT1s – but we held them, as many of our peers did and still do. Many bond funds have drifted steadily towards higher-risk assets, a habit formed when quantitative easing and near-zero yields left managers reaching for something, anything, to justify the label on their funds. But why still do that when you don’t need to?

Drawing the line on these instruments was a deliberate refinement of approaches we have each spent our careers developing. This marks a clear difference from most strategic and global bond funds without radically changing investment processes that work. And by doing so, we think it improves our chances of delivering what clients actually want from a core bond holding: incremental wins and lower volatility, rather than trying to shoot the lights out.

Bonds behaving like bonds

None of what we leave out is bad in itself; they may have a role for investors who want that risk profile. The trouble comes when they are included in something sold as a bond fund, because each chips away at the qualities the client thought they were buying. And what is ruled out entirely is only half of it. The rest is ruled down: high yield and emerging market exposure capped, duration limited, no single position large enough to do real damage.

This sort of restraint can look unambitious when markets are on a tear, and riskier trades are paying off. Its value shows up later, in periods that test whether income was real or merely borrowed from the future. 

So, when a manager tells you what they own, listen politely. When they tell you what they will never own, and explain why, you are hearing something more revealing: what they believe bonds are actually for.

References
1. S&P Global, 2025 Annual Global Corporate Default And Rating Transition Study, March 2026
2. S&P Global, Global Refinancing: Pressures Linger For The Lowest-Rated Credit, October 2025
3. Reuters, BFF Bank flags potential $1.5 billion rise in past-due credit exposure, March 2026