So why, after years of warnings over the risk of higher base rates, are investors piling into bonds at a decidedly risky time?
The answer is strategic bond funds. Investors’ desire for fixed income flexibility meant these ‘go-anywhere’ portfolios took in more than half of the fixed income total – £7.5bn – making the sector the most popular of the 38 categories in the Investment Association universe.
In doing so, fund buyers may be implicitly accepting the best of a bad lot: whatever happens to bonds, few are willing to divest from the asset class entirely, particularly given the diversification benefits that fixed income usually provides in relation to equity positions. That means they must find ways to mitigate the damage.
Strategic bond funds, which can short the asset class, are sometimes seen as a way of doing exactly that. The reality, however, is often somewhat different. No fund in the sector is net short, and many are full of high-yield bonds – which have performed well but are more correlated with equities than the typical bond fund buyer may wish.
Last month’s Investment Insight feature outlined some of the worries facing ‘junk’ bonds. Years of strong returns have made some investors cautious, and there are signs that ‘late cycle’ imprudence is creeping into the way sellers offer their debt to the market.
The typical strategic bond offering has a third of its assets in these riskier bonds, according to Money Management analysis of 15 funds in the sector explicitly named Strategic Bond. There is nothing inherently wrong with this strategy, of course: high-yield bonds are not doomed to a period of underperformance. Of more concern to advisers may be the number of portfolios that decline to break down the credit rating of their underlying assets. At a time when the potential downsides for fixed income are front and centre, this lack of transparency is unlikely to be welcomed by fund selectors.
Income
One of the advantages of sizeable high-yield holdings is the income on offer from these bonds. With absolute return bond funds now offering an even more cautious take on the asset class, the need for income – as much as flexibility – has played a key role in strategic bond funds’ rise to the top of the sales charts.
