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The pros and cons of bondsDiversity is key in the modern bond market
It is well-known that different bond market sectors perform well at different points in economic and market cycles. Throw into the mix the variety of regional bond markets each with their own dynamic, and it is clear that the modern bond market is not only large, but also offers opportunities to diversify within it.
Diversity is where strategic bond funds come into their own. These funds have the flexibility to invest across global fixed income markets, with the potential to deliver strong returns in all conditions, regardless of market volatility or economic uncertainty. This can be attractive for investors who are comfortable delegating their fixed income asset allocation to an investment manager.
Strategic (or unconstrained) bond funds have no shortage of choice. But where to start? There are more than 26,000 publicly quoted bonds in the US alone, plus 9,600 bonds in the Barclays Global Aggregate Investment Grade Index and a further 3,600 bonds in the Bank of America Merrill Lynch High Yield universe . These figures do not even include local currency bonds.
The potential strategic bond marketplace is huge, as are the investment opportunities and the potential pitfalls. When strategic bond funds are referred to as ‘unconstrained’ it means the funds are not benchmarked against traditional indices and so have no discreet universe of bonds to act as a reference.
The benchmarked-based world is where most bond assets are managed – but this sort of easy comparison is not available to strategic bond investors. With no benchmark to refer to, it is important for investors to establish what strategic bond funds can do – and arguably should not do.
A key measure for investors to compare between strategic funds, and to gauge where and in what they invest, is to look at volatility of returns. This enables them to see if managers are using their freedoms effectively. For some funds ‘freedoms’ extend to many areas.
For example, many funds will actively buy assets unhedged with the aim of seeking performance from foreign exchange markets. Similarly it is not untypical to see managers using much of their freedom to buy equities in part of their portfolios. Finally, option strategies can supercharge performance and volatility, again adding to portfolios.
Some managers run lower volatility portfolios as they believe that bond funds should focus on bonds and avoid the props of foreign exchange, equities or options to achieve returns. The fixed income specialists at Kames Capital believe that investors should focus on the three main drivers of unconstrained bond returns: duration, allocation and selection.
