Strategic Bonds  

Strategic options for investment

This article is part of
Strategic bond funds: the right alternative?

Strategic options for investment

The strategic bond fund sector has seen massive growth in recent years. Having overtaken the UK gilts sector in 2010, within the broad fixed income universe it is now second in size only to UK corporate bonds. Funds under management have increased from just over £10bn in 2008 to nearly £40bn today, accounting for nearly a quarter of total fixed income assets, according to data from the Investment Association.

How then do strategic bond funds differ from conventional bond funds? Funds in the traditional gilt and corporate bond sectors operate under relatively restrictive guidelines set up by the Investment Association.  

UK gilt funds must invest at least 95 per cent of assets in sterling denominated (or hedged back to sterling) government backed securities, with at least 80 per cent invested in gilts. UK corporate bond funds have to invest at least 80 per cent in sterling denominated (or hedged back to sterling) investment grade bonds.  

On the other hand, strategic bond funds operate under fewer constraints. Eighty per cent of assets must be invested in sterling denominated (or hedged back to sterling) fixed interest securities, although this excludes convertible bonds, preference shares and permanent interest bearing shares (PIBs).  

Strategic bond funds are also allowed to use derivatives in order to hedge exposure. With no restrictions on the quality, maturity (with the exception of ultra-short dated bonds) and location of bonds, managers can pursue different strategies by investing across the universe of mainstream global bonds, both government and corporate.  

This flexibility frees managers from adhering to a rigid benchmark in order to potentially maximise their capital return; essentially allowing the fund to provide a pure expression of the macroeconomic views of the manager on diverse factors such as the yield curve, interest rates, inflation and – to a certain extent – foreign exchange.   

Given the potential to invest in a range of different fixed income assets – and therefore avoid being restricted to a narrow segment of the bond universe during a bear market – strategic bonds should theoretically be able to outperform traditional bonds over the course of the economic cycle.

As a result of their flexibility, strategic bond funds typically have higher yields than traditional funds. This factor alone may help to explain the rise in inflows to the sector in recent years. Interest rates have fallen and yields on gilts and corporate bonds have been under relentless downward pressure, meaning investors have been forced to look elsewhere in order to achieve adequate returns.

With the benchmark 10-year gilt yield at about 1 per cent, future upside looks limited in government bonds. By way of contrast, at the time of writing the highest yielding fund in the strategic bond sector, the L&G Dynamic Bond Trust, has a yield of 6.9 per cent due to its focus on higher yielding non-investment grade bonds located within emerging markets, which are typically higher risk than gilt or corporate bond funds.  

Clearly, strategic bond funds use active as opposed to passive strategies, which typically follow an index. I believe a passive strategy, which can provide liquid exposure to markets at low cost, is a sensible approach to take in some sectors. For example, there is a limited supply of index-linked gilt issues available, meaning most funds in the sector tend to hold similar securities. Active managers can therefore offer little value.