Given continued equity market volatility and the fact traditional ‘safe haven’ investment options such as government bonds are offering historically low yields, it is little wonder that investors are looking for alternatives.
Latest sales figures from the Investment Management Association for March showed fixed income was the most popular asset class as a whole for the seventh month in a row with net retail sales of £660m. In addition, the IMA Sterling Strategic Bond sector was the best selling of all IMA sectors for the month.
The sector, which contains funds that invest at least 80 per cent of their assets in sterling denominated fixed interest securities - or securities that are hedged back to Sterling - recorded net retail sales of £366m, the highest figure since April 2011, and significantly above the monthly average for the previous 12 months of £211m.
Investor inflows into these funds mean it is the second largest fixed income sector at £25.6bn, second only to the £52.8bn Sterling Corporate Bond sector.
For the year to date to 7 May 2012 it has returned 4.7 per cent, outperforming both the Sterling Corporate Bond sector’s 3.8 per cent and the Global Bonds sector’s return of 1.6 per cent, according to FE Analytics.
However, over the twelve months to 7 May the sector has returned 3.9 per cent, underperforming the Corporate Bond sector which produced a 4.5 per cent return. So why are these funds attracting people’s money?
Flexibility
Andrew Sutherland, head of credit and aggregate at Standard Life Investments and manager of the £92.1m Standard Life Investments Strategic Bond fund, points out most people think of bonds as a homogenous universe with very little differences.
But he adds: “There’s a vast amount of difference in terms of risk and performance in bonds. You’ve got high yield which is very cyclical and high yielding, but you’ve also got your government bonds and things like index-linked and investment grade corporate bonds. So there’s quite a lot of variety and they all do different things at different times.”
The manager points out in the current environment, where the market moves from a risk-on to risk-off view in the space of weeks or even days, strategic bond funds can give investors an advantage.
“Strategic bonds really should offer the ability to take advantage of that [environment] and move around within a wide range of possible bond possibilities to the best effect for investors.
“What you’re really looking for is flexibility and you’re also looking for a [investment] house that’s got a range of skills, or has the full skill set in house already so that the fund can take advantage of that,” he explains.
The ability of global strategic bond funds to invest not only across the credit spectrum but also in different regions, in theory means risks in one area can be offset in another, Mr Sutherland adds.
He notes that currently there are many opportunities within the high yield sector, with the SLI Strategic Bond fund holding approximately 40 per cent in high yield, a 20 per cent core holding in gilts and the remaining 40 per cent in investment grade corporate bonds.
“Generally we like credit [as] we think you’re getting paid for the risk, as there’s a bit of volatility,” he says.
Like many strategic bond funds the manager can use a derivative overlay on the portfolio to provide insurance for tail risk type events such as Europe breaking up or China going into recession.
“For example we would be a lot more positive on the US than we would on Europe, so as quite a nice hedge on Europe experiencing a sharp downturn we’ve gone short the European credit markets and gone long the US credit markets,” says Mr Sutherland.
Other types of overlays include pair trades and hedging high yield exposure through tools such as interest rate swaps.
“So you’re working with the underlying core portfolio but have a flexible approach with the overlay that’s designed to mitigate tail risk but also provide protection,” he adds.
Diversification
Patrick Connolly, certified financial planner at AWD Chase de Vere, says that in difficult and unpredictable times, strategic bond funds can play an important role in investor portfolios.
“Strategic bond funds can effectively be a whole fixed interest portfolio in one, meaning that investors don’t have to be concerned with getting their underlying asset allocation between gilts, investment grade, high yield and overseas bonds right,” he explains.
“The mix of investments held within strategic bond funds means they have the potential to perform well regardless of which type of fixed interest holdings are performing the best.”
With the outlook for the global economy continuing to remain uncertain, particularly regarding Europe, the appeal for an all in one fixed income fund may continue to draw investors.
Nick Gartside, international chief investment officer for fixed income at JP Morgan Asset Management, points out the reaction of the central bank has arguably removed some of the tail risk for Europe.
“Yes, domestic economies look dreadful; yes, the political situation is tense. But both of these are ‘knowns’. Perhaps the risk, with initiatives like the Spanish bad bank plan or the EIB infrastructure plan is that the tone in Europe improves?
“Meanwhile, government yields continue to crunch lower and lower and credit spreads continue to contract. Ultimately, this remains a great backdrop for fixed income and returns from a global opportunity set are likely to continue to surprise.”
Mr Sutherland acknowledges the outlook is quite complicated for the fixed income market, but the core view is of stable but low economic growth, with government yields possibly rising slightly at some point, while credit spreads are likely to come down.
Meanwhile Mr Collins warns: “It is important that investors understand the risks being taken by their fund managers as some will take punchy bets. If this happens, and the managers get it wrong, investors could lose more money than they might expect in a fixed interest fund.”
So while an all-in-one bond solution looks appealing, as with all investments the key is to know what the manager is investing in and making sure it truly is a strategic bond fund that makes use of its flexibility to invest across both the asset class and the globe.
