Fixed IncomeApr 4 2016

More flexibility may yield better returns

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More flexibility may yield better returns

Strategic bond funds have the ability to invest across the fixed income spectrum, meaning they should be able to deliver steady returns while also avoiding taking too much risk.

“A strategic bond fund can, in theory, have a more flexible approach to bond investment than a traditional corporate or high yield bond fund. A corporate bond fund would tend to be narrowly focused on higher credit quality, mainly investment grade, corporate bonds and a high yield bond fund on lower credit quality corporate bonds, but with a commensurately higher return or yield,” explains Craig Veysey, manager of the Sanlam Strategic Investment Grade Bond fund. “This added flexibility may allow a better risk-adjusted return for investors in the strategic bond fund, compared to a fund narrowly focused on only high or low credit quality corporate bonds, if the manager of the fund is able to use their flexibility wisely across the various bond asset classes they may invest in.”

Judging the performance of strategic bond funds, which sit in the Investment Association Sterling Strategic Bond fund sector, can be difficult because, within this peer group, managers adopt a range of strategies, and comparing performance against corporate and high yield bond funds also poses some problems.

“However, on average, strategic bond funds have tended to be positioned somewhere between the investment grade and high yield sectors, with lower duration than investment grade but more credit risk, and higher duration than high yield but lower credit risk,” says Gordon Harding, fixed interest investment director at M&G Investments. “This means they have underperformed investment grade during ‘risk-off’ periods, where credit has performed poorly and safer haven longer duration assets have rallied, but have done relatively well when the market has been more receptive to risk.”

According to FE Analytics, over the three years to March 23 2016, the IA Sterling Strategic Bond fund sector sits firmly between the other two bond fund sectors. The strategic bond peer group generated an average 8.6 per cent return over the period, while the IA Sterling High Yield sector returned 7.4 per cent and the IA Sterling Corporate Bond sector delivered 11 per cent.

EXPERT VIEW– Comparing the peer group

Looking at the performance of strategic bond funds highlights one of the issues with these funds – the way they are categorised. Mark Munro, investment director, credit, at Standard Life Investments, asserts the Sterling Strategic Bond sector is the most disparate peer group in the UK.

“I think the sector has evolved and strategic bond is an interesting name but it’s become a kind of hotchpotch of every single fund that doesn’t sit either in the investment grade profile, so 80 per cent investment grade minimum, or in the high yield profile, so 80 per cent high yield minimum. It’s almost everything outside of that and, as our industry has developed, there’s actually quite a lot of stuff outside that.

“I would say it’s very important for clients to understand what they’re buying in the strategic bond sector. There are many good funds and there are many good strategies but there are strategies that work very well on certain time frames and very poorly on other time frames. Clients must also be comfortable with what they’re buying through a full five- to seven-year macro and credit cycle.”

“It’s no surprise the strategic sector sits in between the two, so giving you better returns than high yield funds over that time period but not quite as good as the investment grade corporate bond sector,” says Mark Munro, investment director, credit, at Standard Life Investments.

The first three months of 2016 were characterised by global equity markets suffering severe bouts of volatility, and credit markets suffered a similar sell-off at first. This has aligned the returns generated by the three bond sectors, with returns now in negative territory. The Sterling Strategic Bond fund made a 1.5 per cent loss in the past 12 months to March 23 2016, while the Sterling Corporate Bond fund was down 1.8 per cent and Sterling High Yield made a 1.3 per cent loss.

Mr Veysey suggests the period at the start of the year demonstrates how bond asset classes may perform differently in various market environments.

He elaborates: “Through to February 10, the best-performing bond asset classes to be invested in were government bonds, in particular long duration core government bonds, as inflation expectations moved significantly lower with commodity prices and investors searched for safe havens from riskier asset classes, such as high yield corporate bonds and equities.

“Subsequently, while core government bond yields remain at fairly low levels, returns have been much greater in corporate bonds – both investment grade and high yield – and riskier government bonds, such as peripheral Europe and emerging markets, as investor sentiment has improved and investors have been on the hunt again for yield enhancement versus low yielding core government bonds.”

EXPERT VIEW– Strategic bond performance

Omar Saeed, manager of the L&G Dynamic Bond Trust, comments on how strategic bond funds deliver returns:

“Credit allocations have been evolving in response to the extended low interest rate environment and, at different points in the market cycle, different asset classes perform better than others. A strategic bond approach is not anchored to any particular duration, market, sector, issuer, rating or currency allocation, generating returns across the global fixed income universe, including specialist asset classes such as high yield and emerging markets, in a dynamic way, without the constraint of a market benchmark.”

Mr Munro adds: “I think the kind of environment where strategic bond funds will work well is a period from here of gradually rising yields in government bonds and the strategic fund sector, which will give you a slightly lower duration profile, and will give you access to credit markets.”

Exactly which area of the credit market that means – whether it’s high yield or investment grade from the US, Europe or emerging markets – is at the discretion of the strategic bond manager.

Ellie Duncan is deputy features editor at Investment Adviser