Is it time to turn to ‘strategic’ bond funds?

Iain Stealey, portfolio manager for fixed income at JP Morgan Asset Management, points out that with the 30-year bond market bull run nearing its end “people need to be a bit more realistic about what their fixed income returns are going to be in the future”.

He adds: “The way we think of the world at the moment is you do want to have that opportunity and be strategic and effectively throw that bond benchmark away.

“People look at their fixed income assets as nice and safe, their ‘safe haven’, but they forget fixed income bonds can be pretty dangerous instruments regarding what can happen with rises in yields and capital losses on some of those.”

Mr Stealey explains that in the current economic environment, “it makes sense to throw the benchmark out of the window and have this unconstrained strategic approach to generate positive returns over a cycle”.

One of the apparent advantages of a strategic bond approach is the flexibility to move between different asset classes.

Stewart Cowley, head of fixed income at Old Mutual Global Investors, suggests that corporate bonds, especially investment grade, “have become the creatures of the government bond markets and have little to commend them, unless you have a manager who is prepared to manage duration (price) risk to the widest possible extent during the updraft in yields when it comes”

He also points out that while high yield bonds remain in demand duration risk is a threat, making shorter maturity high yield the best option in this area. He warns: “Investors are just about to find out that ‘yields are not returns’ in the bond world.”

Mr Cowley continues: “The case for strategic bond funds - by that we mean funds with many levers in them not just the switching between investment grade and high yield corporate bonds against a market index - has risen recently.

“Clients and fund managers are going to need as much flexibility as possible – it’s going to be a long year.”

Asset allocation

Chris Higham, manager of the Aviva Investors Strategic Bond, Corporate Bond and High Yield Bond funds, explains a strategic bond fund is essentially an asset allocation vehicle, although it isn’t necessarily perfect for every client.

“I would say if you were to own only one fixed income product, a strategic bond is likely to be the one for you. But you are in effect outsourcing your fixed income allocation to that investment house. Some clients will like the flexibility of making their own asset allocation calls.”

Nick Hayes, manager of the AXA Global Strategic Bond fund, agrees that fixed income investors either want to outsource their asset allocation or do it themselves.

“I can’t really imagine why clients would suddenly want to buy a strategic bond fund if they haven’t bought it before, or vice versa. I can’t get any different types of high yield or investment grade.

“If they think the yields aren’t right either they want to buy government bonds or they want to allow me to do it all the time. So this debate sometimes, when people say yields are too low on high yield or government bonds and is it time to buy a strategic bond, I think that’s a bit of a misnomer.

“Either they want to do their own asset allocation or they want to outsource it.”

Backing the right horse

However, once a decision has been made to ‘outsource’ to a strategic bond fund, the question is how do you pick the right one? Especially as the IMA Sterling Strategic Bond sector currently has more than 70 constituents.

Richard Hodges, manager of the L&G Investments’ Dynamic Bond Trust, argues clients should have a core holding of strategic bond funds as they should give a greater consistency of returns than single strategy funds that will suffer the cyclicalities of their own asset class.

But he warns investors need to be careful of what is and is not a strategic bond fund, even if they sit within the strategic bond fund universe.

“Certain funds have certain attributes that very rarely change; funds with a name like high income for instance that are in the strategic bond universe. High income funds will, generically, have very little capital protection when markets sell off or government bond yields rise.

“Why would a high income fund ever take the income level down to preserve capital? It’s not what they’re supposed to be doing. So what is a fund with a name like high income doing in the strategic bond universe?

“Then there are funds that invest in other funds; there are funds that are historically high yield at 50-70 per cent and will probably remain 50-70 per cent high yield. What is strategic about that?

“Investors have to pick very carefully the ones that look to generate returns from all sources of alpha within fixed income rather than just predominately relying on one source, as they are susceptible to the largest drawdowns where markets sell off.”

Spotting the difference

Mr Hayes agrees that as the market has developed, and continues to develop, there are clear differences between strategic bond funds.

“Some have a natural propensity to have a lot more high yield, some to emerging markets, I think the understanding of what you are buying is very, very important and the performance really shows that.

“You see those that perform best when you have aggressive spread tightening, and you have those that have a bias towards certain geographies.”

Mr Stealey adds that while there is nothing wrong with these different types of funds, “it is up to the client to understand it’s a catch-all category and to be aware what is in that strategic bond fund and what the investment process is”.

While strategic bond funds are meant to deliver consistent returns without the volatility of a single strategy fund, in an uncertain environment it is clear investors need to make a decision.

Do they want to outsource the decisions to a fund house or do they prefer to make their own decisions. Both offer flexibility in asset allocation the only difference is in who makes the decisions.