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.
Indeed, the average portfolio in Table 1, which details the best-performing funds in the sector over five years, has a yield of 4.1 per cent. That is higher than most equity income funds, let alone corporate or government bond portfolios.
Yield has become even more important as capital losses start to materialise. The table also shows that many of the top 20 funds over five years have struggled across the past 12 months, even when their income payouts are taken into account.
Complications
There are signs that this drop-off in performance is starting to affect investors’ thinking. In the past couple of months, the popularity of strategic bond funds has waned in a way not seen for several years. Net outflows of £181m in March were followed by meagre net inflows of £29m in April, the latest month for which data is available.
But while performance has started to stutter for some, the three best funds over five years also take the accolades across shorter time horizons. Gam Star Credit Opportunities, Royal London Sterling Extra Yield Bond and Sanlam Strategic Bond top the table over one, three and five years, suggesting a degree of resilience not found elsewhere.
Comparing the trio of funds is difficult, given the differing degrees of disclosure provided by their standard factsheets. Gam categorises its holdings by type of bond, Sanlam does so by sector, and Royal London Asset Management (RLAM), the most comprehensive of the trio, does so by sector, maturity, geography and credit rating.
There are some commonalities nonetheless. Chief among these is the affinity for bonds issued by financial services firms. It is true that such companies make up a sizeable part of the corporate bond market, but banks in particular feature prominently. RLAM favours the sector less heavily than its two rivals, but investment-grade debt from Santander does represent the Extra Yield fund’s 10th largest holding.
As Money Management has pointed out in several recent sector analyses, assessing funds’ near-term performance should always take into account the boost provided to overseas holdings from the sharp fall in the pound in mid-2016. For sterling strategic bond funds, whose holdings are largely denominated in the UK currency, this impact was less significant. But corporate bonds did benefit from a flight to safety around the same time, helping the sector to a 8.2 per cent increase in 2016-17.
Gains have been rather more muted both before and since that summer – but this will hardly have been a worry for fund holders. A steady return and a decent income is all a selector could wish for from such a portfolio.
Yet the dispersion of returns across the sector could start to increase as rates continue to rise. There are a variety of portfolios grouped under the Strategic Bond banner – those focusing explicitly on either income, corporate credit or a particular duration of bond being the most prominent. Investors looking to choose between these funds would benefit from greater openness about what’s going on under the bonnet.
