Fights with the Fed? Bond fund selections

​First signs, yesterday, of another shoe starting to drop. Ten-year Treasuries had their best day since May and shorter-dated bond yields also ticked down slightly as investors sought refuge in fixed income.

That may prove significant, because the current equity slump still differs from those in recent years in one crucial way: volatility hasn't yet materially altered US rate hike expectations.

That may change, but either way it's time for bond managers to earn their keep.

Rising rates haven't come out of the blue, clearly. Wealth managers have been aware of the risks for years now. The lure of alternatives may have grown stronger as a result, but few allocators have given up on fixed income entirely.

The most obvious ways to express caution within the asset class are either short duration funds or more flexible mandates such as strategic bond and absolute return products. The first chart below shows the average weighting to each within a typical DFM Balanced portfolio, as measured by our asset allocation database.

One reason why strategic bonds are winning out is the higher yields on offer. The downside, as shown by the second chart, comes in the form of greater interest rate risk. The more cautious absolute return bond funds, by contrast, have a typical duration of 2.1 years.

Some widely-held strategic bond funds are managing to match those levels: M&G Optimal Income has a duration of 2.2 years, and Schroder Strategic Credit comes in at just 2 years.

Despite everything, these funds are still far from fully usurping their more traditional peers. The average weighting to fixed income of all stripes in a DFM balanced portfolio is 20 per cent. Short duration and flexible offerings take up 7 percentage points, meaning plenty of room is still given to investment grade, high yield, inflation-linked and, yes, even government bond funds.

Bond market passes another liquidity test

​It's no surprise that Gam's liquidation of its absolute return bond fund is proving painful for the company: suspending a manager and then liquidating his £7.5bn strategy has an understandable impact on perceptions. So there was a sense of inevitability about the firm's Q3 results yesterday, which showed £2bn was withdrawn from other bond funds on top of the £2.5bn that exited the AR fund prior to its gating.

Perhaps more surprising is the progress the firm has made in liquidating the remaining £5bn of suspended assets. Its main Sicav sold more than 80 per cent of its holdings between August and September. Though illiquid securities remain (not least in its Cayman-domiciled portfolio), the episode is the latest evidence that bond fund liquidity might not be the bogey it's made out to be.

As with the Third Avenue high-yield fund suspension at the end of 2015, and the major outflows from Bill Gross' former Pimco fund earlier that same year, managers have again been able to sell a significant amount of assets that the market knew were coming. 

Partly, then, this is a story about gating: in keeping with the property fund suspensions in the summer of 2016, making an announcement that forced selling is imminent doesn't appear to have been unduly damaging.

On a day-to-day basis, liquidity clearly remains an issue for bond managers in particular, and fund firm traders are having to work both harder and more closely with fixed income desks. But the wider market keeps passing each test with flying colours.

It's not unreasonable for the likes of Mark Carney to keep on warning about open-ended funds, given monetary policy is becoming ever tighter. The Bank of England's Financial Policy Committee has said the FCA's recent recommendations over illiquid assets - for funds to be more willing to gate in the event of stress - "may not go far enough". For now, though, the system is working.

How this morning's moves are affecting portfolios

A calmer morning for markets hasn't been without its slip-ups. Shares in Stobart Group sold off to the tune of 7 per cent this morning on the news of rising losses. It caps off a rocky time for the infrastructure business, which has been embroiled in a fight for boardroom control.

Fund managers have not shied away from this high-profile battle, with Neil Woodford stepping into the fray some time ago. But Mr Woodford, whose flagship fund had 2.7 per cent allocated to the stock, is not the only holder.

Morningstar data as of 30 September indicates Mark Barnett is a backer, with exposure around 1.5 per cent each in his Invesco Income and High Income funds. 

Gravis UK Infrastructure Income, a popular infrastructure play among DFMs, has a 3 per cent stake. On the investment trust front, the Diverse Income Trust, co-managed by Miton's Gervais Williams, has 2 per cent.

Stobart hasn't been the only stock-specific hit during a shaky week so far. Shares in European chemical giant Bayer tumbled yesterday after a judge upheld a court ruling ordering the group to pay damages to a terminal cancer patient exposed to weedkillers.

That story has further to play out, but Bayer shares have today slipped to a fresh six-year low and several popular funds could be licking their wounds here. Invesco Global Opportunities, in particular, had a stake of nearly 8 per cent at the start of this month.

Sanditon European and JOHCM Continental European each had around 5 per cent of their portfolios invested, while Alexander Darwall's Jupiter European had 3.7 per cent. Crux European Special Situations had 2.5 per cent, while Invesco European Equity Income had a 2.6 per cent position.

The major caveat is that all this data is estimated to 30 September. Bayer's struggles first began that month, so worried managers may have cut positions already.