Diversity is key in the modern bond market

Diversity is where strategic bond funds come into their own. These funds have the flexibility to invest across global fixed income markets, with the potential to deliver strong returns in all conditions, regardless of market volatility or economic uncertainty. This can be attractive for investors who are comfortable delegating their fixed income asset allocation to an investment manager.

Strategic (or unconstrained) bond funds have no shortage of choice. But where to start? There are more than 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 . These figures do not even include local currency bonds.

The potential strategic bond marketplace 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 so have no discreet universe of bonds to act as a reference.

The benchmarked-based world is where most bond assets are managed – but this sort of easy comparison is not available to strategic bond investors. With no benchmark to refer to, it is important for investors to establish what strategic bond funds can do – and arguably should not do.

A key measure for investors to compare between strategic funds, and to gauge where and in what they invest, is to look at volatility of returns. This enables them to see if managers are using their freedoms effectively. For some funds ‘freedoms’ extend to many areas.

For example, 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. Finally, option strategies can supercharge performance and volatility, again adding to portfolios. 

Some managers run lower volatility portfolios as they believe that bond funds should focus on bonds and avoid the props of foreign exchange, equities or options to achieve returns. The fixed income specialists at Kames Capital believe that investors should focus on the three main drivers of unconstrained bond returns: duration, allocation and selection.

In the summer of 2013, following the ‘taper tantrum’ crisis of May and June, there was no shortage of articles proclaiming the end of the three-decade bull market in bonds. Three years on and these were not the headlines for July and August 2016 as the world’s government bonds markets bulldozed their way through new historic highs day after day.

But September’s mere 20bps-30bps back-up in 10-year yields is already leading some commentators to dust off their old articles. Expect more on the end of the great bond bull run as and when yields drift higher. These sensationalist headlines need a context – and need to be squared with real-world decisions in fixed income allocation.

Bond yields have collapsed since 2013 and the market’s duration greatly extended. Yields have been driven lower by low, or no, inflation expectations and quantitative easing in Europe and Japan (and recently in the UK). From a general investors’ perspective, value has left the equation for bond markets over the past year, and so too for most managers of unconstrained bond funds.

Still, total returns from unconstrained bond funds have generally met investors' expectations, mainly through allocations to high yield and investment grade credits, where some relative value is justifiable. Most managers have baulked at adding duration at new highs and so may not have reaped the full benefits of the duration rally.

But they can be forgiven for missing out on the rally of the 10-year bund from zero to -10bps, and any increase in government bond yields from here will highlight the defensive qualities of unconstrained bond funds.

So what are the investment opportunities for unconstrained funds? Managers use a variety of tools to generate returns: duration, yield curves and cross market plays, as well as credit – both investment grade as well as high yield (and in some cases foreign exchange). And they can look to implement these tools across the broad spectrum of regional markets. 

Duration of course remains a key driver of returns and, given current yield levels, it is also a source of concern. There has been a dramatic increase in duration for European government bond indices of 7.7 years.

While there has been an increase in the issuance of longer maturity bonds this has been mostly driven by the increase in price of existing bonds.

Selecting the right maturity in bond portfolios is one of the more important decisions in duration management. For example, the 30-year gilt’s 10-point rally felt good for August this year, but September’s sell-off of the same amount did not feel so clever.

In the meantime two-year gilts traded in a range of around 30 cents in August and September. Yield curve shapes are the bread and butter of fixed income managers and strategic funds give managers the opportunity to choose where they want to be positioned along the yield curve.

While Kames Capital believes rates are set on a path of ‘lower for longer’, there is little doubt this is priced into current valuations. In this respect, investors are more likely to feel comfortable with the defensive stance of most unconstrained bond funds.

Decisions to allocate between rates, investment grade, emerging or high yield markets are core to unconstrained management, particularly in order to manage risk.

It may be, for example, that BB-rated bonds provide the best returns in 2016, but it would be imprudent to invest all the assets in an unconstrained fund in BB bonds. Managers will typically look to allocate to an individual bond on a ratings and geographical basis. The allocation process will also consider the weighting between government markets (again capturing the geographic allocation) as well as by sectors for credit markets.

The returns from government bond markets may be dominating the headlines of late, but credit selection typically has a significant impact on overall returns, which is highlighted in the strong performance of individual names in 2015.

Owning BHP Billiton as opposed to Glencore, National Grid rather than RWE or Daimler rather VW had a material impact on fund returns. Inevitably, investors will need to feel comfortable with a manager’s selection process and historic abilities. A well-resourced team with good coverage of markets is a good starting point.

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 investors. 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 the remainder of 2016. The ability to shuffle assets along with understanding the drivers of duration, allocation and selection risk will, as ever, be the key drivers of returns.

Adrian Hull is senior fixed income investment specialist at Kames Capital

Key points

Diversity is where strategic bond funds come into their own.

Many funds will actively buy assets unhedged with the aim of seeking performance from foreign exchange markets.

Investors are more likely to feel comfortable with the defensive stance of most unconstrained bond funds.