Strategic options for investment

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.  

The downside of adopting a passive strategy in other areas, notably the corporate bond sector, is that bonds tend to be selected on the merits of liquidity. In the long term, I believe this could lead to underperformance as investors have unwittingly bid up prices, increasing volatility in the process. An active strategy allows the potential for superior long-term returns, dependent on the skill of the manager and his research team. Timing and stock selection are key.

However, in the strategic bond sector, where the benchmark is essentially unconstrained, there is a wider dispersion in returns of individual funds both on the upside and downside where managers underperform. As a result, due diligence on fund managers and their investment houses is crucial. I recommend investors scrutinise the long-term record of funds, especially in relation to risk and return, the credentials of the fund managers, including the length of tenure in their current role, and achieve a clear understanding of each fund’s strategy and how it would fit in their portfolios before investing.

Having considered the theory, how do these funds stack up in practice? The table shows the long-term performance of the different Investment Association bond sectors over the past 20 years to the end of April 2017.

Source: FE Analytics

Note: *Assuming a long-term risk-free rate of 2 per cent

At first glance, the strategic bond sector has performed poorly against other fixed income sectors. Not only has it achieved the lowest annualised returns at just 2.3 per cent, but risk-adjusted performance, as measured by the Sharpe Ratio, has been the worst too, arguably suggesting the risk is not worth the reward.  

Returns have also lagged over the one, three, five and 10-year periods. However, over these timeframes volatility has consistently been the lowest, resulting in an improved Sharpe Ratio, favourable to other sectors. One should also bear in mind that returns over 20 years do not accurately reflect the current constituents of the index because of the sector's rapid growth during that time.

Despite these caveats, the undeniable conclusion is that strategic bond funds as a whole offer a generally cautious approach to fixed income investment. I would suggest this is due to the use of derivatives; credit default swaps and bond futures are widely used to limit downside risk. Given that we have been, and arguably remain, in a long-term bond bull market, it is clear to see why the sector has underperformed. Gains made by the underlying bonds have been offset by losses from derivatives. The sector is therefore suitable for investors who are considering lower risk exposure to the sector, but still require income.

The Jupiter Strategic Bond Fund is one fund I believe merits attention. Managed continuously by Ariel Bezalel since inception in 2008, the fund has outperformed the benchmark (IBOXX UK Sterling Non Gilts), delivering a return of over 100 per cent to date. The fund has an international focus, with the largest allocations in the UK, Asia Pacific and North America, and generates a yield of 4 per cent, largely through exposure to corporate bonds.

Average credit quality is BBB, although the fund invests in a wide range of issues, ranging from AAA to not rated. Offsetting the long holdings, the fund has short positions in Europe and Japan and is set to benefit if yields pick up in these countries from historic lows. 

John Goodall is head of private client research at WH Ireland

Key points 

Strategic bond funds operate under fewer constraints than other types of bond funds.

Strategic bond funds use active as opposed to passive strategies.

Volatility has consistently been the lowest in strategic bond funds.

How to build a strategic bond fund

In building a strategic bond fund, it is first important to form a broad macroeconomic view before even considering portfolio construction. Once in place, this will naturally filter through to the selection of securities and derivatives. We are currently experiencing one of the slowest economic recoveries on record with GDP in the US, the world’s leading economy, having grown at an annualised rate of just 1.2 per cent over the past 10 years.  

However, with the expansion now the third longest on record, nearly double the average length since 1945, it is fair to say we are in the late recovery stage of the economic cycle. Leading indicators do not look broadly positive with, for example, a visibly softer trend in payroll growth and total loan growth dropping to a fresh three-year low with weakness seen across commercial and industrial, real estate and consumer loans.

In a normal environment, one would expect this to be very positive for bonds. However, the role of government intervention cannot be overlooked. Prices of all financial assets, bonds in particular, have been distorted by government buying in recent years.  

As the US Federal Reserve reduces its support and unwinds its balance sheet, there are fears that yields will spike. Although I acknowledge these concerns, the recent experience has been the opposite. Despite the US hiking interest rates, I have actually observed a flattening in the yield curve as investors remain wary about the long-term potential for rate hikes. A combination of high existing debt, ageing demographics and rapid technology growth is likely to weigh on prospects for inflation, keeping interest rates and bond yields at structurally lower rates in the future.

I favour US Treasuries, which still offer value, particularly at the medium to longer end of the yield curve. Even as the Federal Reserve pulls out I still expect to find buyers to support prices. The UK also looks attractive as interest rate increases look implausible. I would look more to the corporate sector, which offers better value than government debt, keeping a close eye on the credit quality.

Europe would be an area to consider for short exposure. Problems in the European banking sector have flared up again recently in Spain with the collapse of Banco Popular, a reminder that the crisis has not ended. The vulnerability of the banking sector – in Spain and Italy, for example – is an inevitable consequence of years of lending to businesses and consumers in a low growth environment.