As investors continue to seek the income stream and relative stability that a well-balanced portfolio of fixed interest investments provides, the popularity of strategic bond strategies is growing.
For Luke Hickmore, co-manager of the Aberdeen Strategic Bond Fund, the appeal of this type of fund is clear: they provide a high level of flexibility with the aim of maximising performance and minimising risk.
He believes there are key challenges facing investors over the coming months, challenges that a well-run strategic bond fund could effectively turn into opportunities.
He says: “First, there is a big shift in liquidity and dealing with that is going to be a key point that I believe investors need to work through over the next year or two. It is moving largely to the primary market, with the secondary market inconsistent, at best. We do not think there is a great rotation out of bonds at the moment, but there is a gradual undertow and it is something every fund manager and saver in the asset class needs to be aware of.
“Second, there is a shift in the political landscape, with a move away from the centre generally raising volatility across the globe. The UK election promises to be fascinating and it seems almost impossible to call the result, which brings a lot of uncertainty into the market.
Away from that, there are also elections in other key European countries, including the recent election in Greece, as well as Spain, Portugal and Sweden.
“Third, there is a shift in rates, with the US leading the UK and Europe. We are already seeing people trying to get ahead of that, with US yields at 2 per cent, which is a good 30bps ahead of where they are in the UK and 150bps ahead of Germany. It is a clear indicator of where rates are moving, but the question is how long the UK and Europe will take to get there, which is a big call to make.”
In terms of where this leaves fixed income funds, in general, Mr Hickmore believes getting the call on duration right will be a pivotal driver of performance. He states that many investment houses have been too negative on the market to date, issuing warnings about the “death of bonds” and a spike in yields. Conversely, he anticipates that, as long as inflation stays low, we are likely to see only small moves in rates this year, with any potential problems only likely to appear next year, at the earliest.
“The other thing managers need to work through is their exposure to investment grade and high yield,” Mr Hickmore adds. “High yield – by which I mean industrial rather than financial high yield – has generally been adequate in the better quality parts of the market and the default rate has remained low. However, at some point in the next year or two investors are going to be faced with the prospect of rising default rates, particularly as liquidity starts to dry up as QE comes to an end in Europe.”