What are the differences between strategic bond funds in the IA sector?

The sector definition is loose enough that fund groups can have different mandates and biases, according to Thomas McMahon, senior analyst at Financial Express.

He explains that some, for example, will target a specific, high yield from all three sectors, while others will attempt to differentiate themselves by specialising in more esoteric assets, although non-core holdings should make up less than 20 per cent of the fund to meet sector rules.

There are also funds with a short duration mandate which should have a very different pattern of behaviour to what he calls the more “mainstream” funds which are focused on calling the credit cycle, as well as funds with a focus entirely on the UK or a more global remit, all of which fall within the loose Investment Association rules.

Macro views

Mr McMahon says: “The second group had a good 2015 but underperformed relative to the first group in 2016.”

“It is also important to remember that a strategic bond manager is essentially trying to judge where the economy is heading, so their macroeconomic views and biases will lead to different behaviour patterns."

Strategic bond funds come with a range of objectives – some are focused on delivering income while others focused on providing diversification, some are marketed as absolute return bond funds while others aim to outperform the peer group.Ashis Dash

“In recent years the key divide has been between those who think the economic cycle has been prolonged due to quantitative easing (QE) but on the verge of an upswing, and those who believe growth and inflation will be semi-permanently lower than past cycles due to 'secular stagnation'.”

Ashis Dash, associate director of fixed income strategies at Morningstar, agrees that most strategic bond funds are managed in a benchmark agnostic manner while the so-called traditional bond funds tend to be more benchmark oriented. 

He says this flexibility means managers can move a fund’s exposure freely across sectors and credit quality spectrum, as well as change its interest rate duration. 

He says: “Varying combinations of these has resulted in a range of differentiated strategies within this space.

“Furthermore, strategic bond funds come with a range of objectives – some are focused on delivering income while others focused on providing diversification, some are marketed as absolute return bond funds while others aim to outperform the peer group. How these funds go about realising their aims varies and funds with similar objectives can achieve their goals through diverse approaches.”

Interest rate risk

Another key differentiator amongst strategic bond funds is their credit exposure. 

Mr Dash says: “While the level of credit beta is usually actively managed, we have seen funds exhibit biases to certain segments of the credit market over the longer run. For example, the Henderson Fixed Interest Monthly Income, Henderson Preference and Bond and Henderson Strategic Bond have historically preferred high-yield bonds, whereas the Fidelity Strategic Bond has generally retained an investment grade bias over the longer term.”

Most strategic bond funds also enjoy considerable leeway in managing their interest rate risk, i.e., duration. 

The ability of a fund manager to react quickly and efficiently to changing markets, supported by an experienced team, is of particular importance given these funds’ highly flexible mandates and broad investment universe.Ariel Bezalel

Mr Dash adds: “A general trend over the last few years amongst many strategic bond funds has been a low duration stance, such as the M&G Optimal Income’s below three-year duration since late 2014. 

“Some mandates take this a step further allowing managers to implement a negative duration position - while such a position would be particularly helpful when bond yields move up, it is also likely to distinguish the fund’s return profile from traditional bond funds that are managed with duration close to their benchmarks.”

He points out some strategic bond funds take on active currency risk. However, such bets tend to be limited due to the higher volatility associated with the currency markets and hence currency generally tends to be a smaller driver of returns in fixed income mandates that dip into this asset class.

Derivatives have also played an increasing role in this space, in implementing ideas (both long and short) as well as hedging portfolios. They can help gain or reduce exposure to credit, rates and currencies markets and can also help move a fund’s exposures swiftly.

Broad investment universe

Finally, funds such as the M&G Optimal Income and Artemis High Income use the flexibility to invest beyond fixed income market into equities (which is more of a strategic allocation for the latter) as a diversifier and an additional source of return.

Mr Bezalel says the key point to remember is that no two strategic bond funds will be the same as no fund manager approach is the same. 

He points out: “Funds vary in their approaches to credit exposure, market maturity, interest rate risk and derivative use, as well as other factors. 

“As ever, due diligence is key when choosing the most appropriate fund manager for your investment goals. In the case of strategic bond funds, investigating the flexibility allowed to the fund manager, their experience and the strength of the wider research team are sensible places to start.

"The ability of a fund manager to react quickly and efficiently to changing markets, supported by an experienced team, is of particular importance given these funds’ highly flexible mandates and broad investment universe.”

According to Morningstar there are three particular points to note when assessing the differences between strategic bond funds:

• Credit exposure - Many funds now in the sector started life as members of its defunct forerunner – UK Other Bond. To qualify for inclusion funds had to hold a minimum portion of their assets in high yield (more commonly known as junk) bonds. Despite the demise of this sector, many older strategic bond funds continue to place high proportions of their portfolios in junk bonds. In contrast, other funds are less tied to the restrictions of the past and are able to vary the credit quality of the portfolio to capitalise on opportunities across the credit range.
• Market maturity - Most strategic bond funds give themselves the leeway to adjust the interest rate exposure of the portfolio to protect or profit from changes in short and long-term interest rates. The degree of flexibility and the skill of the manager will determine the return investors receive throughout the market cycle.
• Derivatives - Funds also vary in their use of derivatives to manage both the interest rate, credit quality and currency exposure of the portfolio. Derivatives can increase the flexibility of the portfolio and provide the manager with additional tools to protect capital. Or they can reduce the transparency of the investment process and make it less easy to predict the impact of market events.

samantha.downes@ft.com