The post-credit crunch world has created a completely new environment for fixed income investors, and what has traditionally been seen as a ‘safer’ alternative to the more risky equity funds has come under closer scrutiny as a result of the impact of decisions made by central banks.
The advent of quantitative easing, first in the UK and more recently in the eurozone as the ECB finally takes the initiative in purchasing assets to support markets, has increased the amount of risk that is inherent in the bonds asset class. The result is that many bond fund managers found their original fund strategies too stifling, leading increasingly to a move towards funds that gave more flexibility in the way they were able to invest for income.
Strategic bond funds are now, according to Jason Hollands of Tilney Bestinvest, “the main game in town for fixed-income exposure for a retail investor”, and the increasing number of funds in this sector is testament to the appeal of fixed-income fund managers having more investment flexibility.
The Investment Association defines the sterling strategic bond sector as “funds which invest at least 80 per cent of their assets in sterling denominated (or hedged back to sterling) fixed-interest securities. This excludes convertibles, preference shares and permanent interest-bearing shares (PIBs)”.
The definition continues: “At any point in time the asset allocation of these funds could theoretically place the fund in one of the other fixed-interest sectors. The funds will remain in this sector on these occasions since it is the manager’s stated intention to retain the right to invest across the sterling fixed-interest credit risk spectrum.”
For clients, this can make it difficult to determine the level of risk they are taking with their fixed- income investment, creating an even greater need for advisers to understand the underlying investments than may be found elsewhere in the fixed-interest sector.
Mr Hollands said: “Central bank asset-purchase programmes have significantly distorted fixed-income markets, decimating yields on sovereign bonds. And that has translated across into the investment grade corporate bond markets and in turn high yield as investors have migrated up the risk curve. As the US and UK progress down the path of normalising monetary policy, however, this will lead to potentially quite severe adjustments to yields and bond prices, so we are approaching a potentially dangerous point.
“With that prospect in mind, you really don’t want to be boxed into one part of the market for your fixed-income exposure, so funds that have flexible mandates to shift duration and move across the full bandwidth of credit spectrum, and have a broad enough toolkit to manage risk, are the right home for fixed-income exposure – providing of course they are well-managed products.”
The ability for strategic bond fund managers to invest across a range of fixed-income assets means that they should be able to protect a client’s investment when things are going badly in fixed income, and maximise their returns when things are going well. But as with any type of managed fund, this is not always the case, and the performance of a fund or manager is almost impossible to predict.
The question of what a ‘well-managed product’ might be is also a moot point, after all, the level of risk that a client is prepared to take in the quest for income will be particular to each individual investor. There is little doubt that fixed income makes up an important part of most people’s portfolio, as it is a way of providing protection against other, more traditionally risky investments such as equities.
However, as a result of the central banks buying up fixed-interest stocks, the traditional risk profile of bonds has changed significantly, with “prices on many fixed-interest assets having risen to artificially high levels”, said Patrick Connolly of Chase de Vere.
He added: “Against this backdrop investors must be very careful. They don’t want to be too over-exposed to fixed interest, but at the same time cash is losing money in real terms and equities are likely to remain volatile. Investors should continue to hold fixed interest and we believe that the best way to achieve this is through strategic bond funds. Within these funds, managers have the flexibility to asset allocate between different fixed-interest investments, which means they can diversify risks and hopefully avoid the most expensive areas.”
The diversity of the approaches adopted in the strategic bond sector means that while some of the best fixed-interest teams in the business are working within this area, the amount of freedom given to each fund manager means it is essential for advisers to dig deeper into the fund itself before making the recommendation as to where a client should invest.
Mr Connolly said: “These funds can vary considerably in terms of the amount of freedom given to the fund manager, the types of assets they typically invest in, the number of holdings they have and the term remaining of individual holdings (duration). It is imperative that advisers do the necessary research before deciding where to invest. Getting it wrong could potentially mean they are taking far more risk than they realise.”
Assets that can be held in strategic bond funds include corporate bonds, strategic bonds, high-yield bonds, plus global bonds and global emerging markets bonds. In addition, it is possible for fund managers to use derivatives “within the spirit of the sector and not lead to the economic exposure of the fund being outside the set limits of its sector”, according to the IA’s notes on the sector’s definition. But this is monitored by self-certification, so it is vital that advisers carefully consider the make-up of each fund being recommended to a client to ensure the level of risk is commensurate with their risk profile.
Of course, having such flexibility gives fund managers the ability to move quickly to minimise losses in one area of fixed interest over another, but getting this right is not easy.
Mr Connolly said: “This relies on the fund managers making the right decisions and, as history shows time and again, many won’t and their investors will suffer as a result. Fixed-interest investments potentially face challenging times ahead, particularly as and when interest rates start to rise. Rising interest rates are bad news for fixed interest, because the fixed rate of interest they pay becomes less appealing when interest rates elsewhere are rising.”
He added: “Many strategic bond managers have already prepared for rising interest rates by investing in shorter duration bonds, meaning they’re not locked into long-term investments at poor rates. This is good for investors if fixed interest falls back, but they could potentially get left behind if interest rates don’t rise and fixed interest in general performs well. So investors in this sector are very much relying on the skill – and luck – of their fund manager to make the right decisions.”
The strategic bond sector was created back in 2008 following a period of what the IA called “dynamic changes” such as the introduction of Ucits III in the fund market for fixed-income products.
A spokesman for the IA, said: “Back in June 2000 the UK General Bonds sector was split into two to create the UK Corporate Bonds sector and the UK Other Bonds sector. In September 2008 UK Corporate Bonds and UK Other Bonds were reorganised into three new sectors: Sterling Corporate Bond, Sterling High Yield and Sterling Strategic Bond.
“The background to the 2008 change followed a period of dynamic changes – for example Ucits III – in the fund market for fixed-income products. We carried out a consultation with key sectors stakeholders, such as members the Association of British Insurers and the European Fund Categorisation Forum, to determine the continued relevance of – or required changes to – our fixed-income sectors, and whether harmonisation with the then recently amended ABI and EFCF sector definitions would be appropriate.
“There was a broad agreement from the consultation that the UK Corporate Bond sector was quite large, and interest was expressed in separating out a pure sterling corporate bond sector which would be more similar to the ABI’s Sterling Corporate Bond sector. Members also favoured the creation of the Sterling Strategic Bond sector, which converged with the newly created ABI Sterling Other Fixed Interest sector. To further enhance the clarity of the fixed-income sectors there was also strong support to separate those funds with higher risk and potentially higher returns through the addition of a Sterling High Yield sector. That is how we got to the current suite of three fixed-income sectors.”
The performance of the sector over the past five years has been far from stellar, with the Sterling Strategic Bond sector returning 35.7 per cent in the past five years, according to figures from FE Trustnet, which is less than half of the returns you would have seen with the top-performing UK Smaller Companies sector, which has returned 98.3 per cent in the same period.
That said, the IA’s figures show that in January, the Sterling Strategic Bond Sector had £32.8bn of funds under management, nearly three times as much as the Global Bond Sector. As you can see from the chart of net retail sales by asset classes, fixed income started to pick up at the beginning of 2015, as both mixed asset and equity funds fell out of favour with retail investors. (http://www.theinvestmentassociation.org/assets/files/press/2015/stats0115-chartb.pdf)
The current economic backdrop has prompted some existing fixed-income funds to change their strategy to increase their flexibility, one of the latest being the Baring Global Bond Trust converting to the Baring Strategic Bond Fund. It will be managed by Guy Dunham, head of Global Aggregate and Richard Balfour, fixed income investment manager at Baring Asset Management (BAM), and will “aim to deliver consistent performance in a range of different market environments and will not be tied to a benchmark”.
Rod Aldridge head of UK Wholesale at BAM, said: “The low interest rate environment and wider market volatility is driving significant demand from investors for more flexible fixed-income products that are able to generate strong and consistent returns. We believe that combining assets from around the globe can increase returns and reduce risk, while actively allocating between sectors can also enhance performance.
“Barings has a track record of successfully managing fixed income portfolios for more than 35 years and the development of the Strategic Bond Fund will complement and capitalise on Baring’s’ specialist investment knowledge. The Baring Strategic Bond Fund and dedicated team behind the fund will showcase our global fixed-income market expertise.”
It is no wonder that investment houses are keen to change the format of their fixed-income funds to get on the strategic bond fund bandwagon, as their popularity with investors is clear. FundsNetwork’s sales figures for last year showed that in the top 10 adviser sales by sector, strategic bond funds were placed fourth, while the M&G Optimal Income Fund was placed first overall in the pension bestsellers list, with Jupiter Strategic Bond Fund coming fourth in the pensions sector, and seventh in the ISA bestsellers list and overall adviser sales list through FundsNetwork.
Jon Everill, head of Advisory Services, FundsNetwork, said: “Last year proved to be quite a volatile year, punctuated in particular by geopolitical risks. This clearly affected investor confidence and resulted in investors seeking the diversification offered by the Mixed Investment sector, which saw strong flows throughout 2014 on our platform.
“With the pension freedoms coming into play this year and more investors looking at drawdown as an at retirement option, I would expect increased interest in income-generating products in 2015, particularly of the multi-asset variant.”
As members of defined contribution pension schemes will have the freedom to access their funds in a manner akin to a bank account after they reach age 55 from April 6, there is likely to be an increase in the number of investors looking to generate income from their funds. Using strategic bond funds could be a sensible answer, but the relevant wealth warnings need to be applied.
Checking under the bonnet is going to be imperative for advisers to determine which strategic bond funds are right for which clients. Laith Khalaf, of Bristol-based Hargreaves Lansdown, said: “Some have a total return focus, and funds we like in this space include Invesco Perpetual Tactical Bond and M&G Optimal Income. Others have more of a high-yield focus – worthy of consideration are Jupiter Strategic Bond and Artemis Strategic Bond.”
Mr Connolly favours the Henderson Strategic Bond fund, and the Jupiter Strategic Bond fund. He said: “The Henderson Strategic Bond is consistently one of the higher-yielding funds in its sector, due to an ongoing weighting of between 20 per cent and 70 per cent in high-yield bonds. It currently has 46 per cent in high-yield bonds, including significant holdings in banks. The fund manager John Pattullo has been at the helm for 15 years and has consistently out-performed over this tenure.
“The Jupiter Strategic Bond is a completely flexible fund where the manager reads a great deal of economic research, takes into account the macro environment and is prepared to make big shifts in asset allocation and invest in some assets which might not be on the radar of other managers.”
However, Mr Hollands finds the smaller funds more appealing. He said: “There are a number of strong teams out there, but some of these funds are now quite large in size, so one of my preferred funds is the PFS TwentyFour Dynamic Bond fund, at a relatively modest £686m. The size means it can take bigger positions in individual credits, which suits a fund with ‘best ideas’ brief including strong expertise in asset-backed securities, where the fund has around 17 per cent exposure.
“TwentyFour is a wholly fixed-income focused boutique, with the key team members drawn from investment banking rather than fund management backgrounds. The fund makes use of derivatives as part of its management of interest rate and credit risk and it also hedges any FX exposure back into sterling, which is important given the pan-European focus of the fund at a time when the euro has weakened materially.”
Alison Steed is a freelance journalist
Key points
The post-credit crunch world has created a completely new environment for fixed-income investors.
Many strategic bond managers have already prepared for rising interest rates by investing in shorter duration bonds.
The performance of the sector over the past five years has been far from stellar.
