There are over 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 – and these figures do not even include local currency bonds. The potential strategic bond universe 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 thus have no discreet universe of bonds on which to reference. For example, in the UK’s investment grade universe there are 1,000 bonds. This discreet group of bonds will make it easier to see a manager’s performance against that benchmark as well as other managers (managing to the same or very similar benchmarks).
Managers will have some flexibility away from that benchmark, but their performance will ultimately be measured against that underlying index as well as against peers with similar targets. This benchmarked-based world is where the majority of bond assets are managed – but none of this easy comparison is available to strategic bond investors. There are three main tenets of strategic bond management – duration, asset allocation and credit selection – but it is important for investors to establish what these funds can and arguably should not do.
A key measure for investors to compare between funds and to gauge where and in what they invest in is to look at volatility of returns. This enables investors to see if managers are effectively using and managing their freedoms. 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 – typically flexibilities allow for holdings of up to 20 per cent of the fund.
Finally, option strategies can supercharge performance and volatility, again adding significantly to portfolios.
The growth of strategic bond funds has been partly driven by concerns over the move to higher rates in government bond markets, with strategic funds seen as avoiding being slavish to benchmarked bond indices. One of the mathematical consequences of low yields over the past few years is that duration has increased. For example, the duration of the Barclays European Aggregate Index of all investment grade bonds increased by 18 per cent from 5.52 years at the end of 2012 to 6.23 years at the end of 2015.
Many issuers have issued longer maturity bonds also adding to the duration of, for example, tracking funds. Selecting the right maturity in bonds portfolios is the second most important decision in duration management. For example, while there was a 425bps rise in US Fed funds between 2004 and 2006 and a similar increase in short dated bonds, 10 year US Treasuries increased by only 60bps. Yield curve shapes and management are the bread and butter of fixed income managers and strategic funds give managers the opportunity to choose the optimal part of a yield curve to be at in any given moment in a rate cycle as well to manage or hedge unwanted duration.
Asset allocation really encapsulates the need to manage risk within an unconstrained bond portfolio. Decisions to allocate between rates, investment grade, emerging or high-yield markets are core to unconstrained management. So it maybe that BB bonds provide the best returns in 2016, but it would be imprudent to invest all the assets in an unconstrained fund in BB bonds. Thus, a reasonable asset allocation process will be needed. Managers will typically look at allocation by a bonds rating as well as by geography. The allocation process will also figure the weighting between government markets (capturing the geographic allocation) as well as by sectors for credit markets. So the basket case of 2008 – financials – was among the strongest-performing credit assets in 2015. And while corporates have generally fared very well since the financial crisis, 2015 saw material underperformance of utility and mining sector bonds.
Despite strong returns in credit markets since 2008 it has been governments rather than corporates that have driven net new supply. Strategic bond managers regularly need to revisit the fund’s core holdings. For example, in 2015, holdings in individual names could have had a strong impact on returns, for instance, owning BHP as opposed to Glencore, National Grid rather than RWE and Daimler rather VW will have made material impact to fund returns. Inevitably investors will need to feel comfortable with a manager’s selection process and historic abilities.
One final vital consideration is liquidity: managers must have flexibility to manage their unconstrained freedoms. Flexibility means moving from one asset type to another to ensure better outcomes for fund holders and to that end, liquidity becomes very important. Managing portfolios of larger bond issuers (typically FTSE, S&P constituents) with deal sizes of at least $500m helps to ensure market price transparency.
Active managers will continue to focus on liquidity for unconstrained funds in 2016. The ability to shuffle assets along with understanding the drivers of duration, allocation and selection risk will as ever drive returns for strategic mangers in 2016.
Adrian Hull is senior fixed income investment specialist at Kames Capital
Key points
* Strategic, or unconstrained, bond funds have huge flexibilities.
* A key measure for investors to compare between funds is to look at volatility of returns.
* Asset allocation encapsulates the need to manage risk within an unconstrained bond portfolio.
