How Strategic is my bond fund?
- Date: 17/01/2017
How Strategic is my bond fund?
With the interest rate cycle at a crossroads, now more than at any time in the post-financial crisis era, investors will need to find the right balance when allocating some (or all) of their fixed income exposure to a Strategic Bond fund. For some investors a Strategic Bond fund offers a one stop shop for all their fixed income needs, however given the wide universe of strategies we would caution against taking this one-size-fits-all approach.
The Investment Association defines the Strategic Bond universe as “Funds which invest at least 80% of their assets in Sterling denominated (or hedged back to Sterling) fixed interest securities… At any point in time the asset allocation of these funds could theoretically place the fund in one of the other Fixed Interest sectors.”
Consequently investors, at any one point, can end up with a fixed income allocation that could be correlated to lower-risk, government bonds or higher risk, high yielding bonds. In reality the IA sector definition gives rise to a wide range of strategies that generate significantly different risk-adjusted return profiles. The matter is only compounded by the fact that there are not enough IA sector classifications across the fixed income asset class. This means some asset managers are forced to ‘dump’ certain funds in to the sector, and inflation-linked bonds are a good example of this.
So how should one start their search for the ubiquitous Strategic Bond fund? Well, therein lies the first mistake - to consider a Strategic Bond fund in isolation is relatively futile. In the first instance investors need to understand what they are looking to achieve from their chosen fund, or more broadly, what role should the fund play in their multi-asset portfolio? From this perspective investors should not consider Strategic Bond funds to be a like-for-like swap for duration in their portfolio. The flexibility of the Strategic Bond mandate allows managers to ramp up (and down) the years of duration in a portfolio without much, if any, constraint.
One categorisation of funds in the Strategic Bond universe can be defined as ‘Unconstrained’. They represent the evolution of the more traditional “Core Plus” strategies which are managed to a broad global bond benchmark with off-benchmark allocations to asset classes like Emerging Market Debt and High Yield. While there may be the flexibility to be short parts of the bond market, either rates or credit, these funds will typically have a higher correlation to movements in the yield curve and credit spreads. Performance is often assessed against composite benchmarks, for example a fund might create a benchmark that is comprised of: 1/3 government bond index, 1/3 investment grade credit and 1/3 high yield (these could be regional or global indices). One example of a strong fund in this space is the M&G Optimal Income Fund.
A second category of fund in the universe can be defined as ‘Multi-Strategy Credit’. These funds contain exposure to a combination of investment grade and sub-investment grade credit. Through active management of the credit beta the fund manager is able to be positioned defensively through greater exposure to cash and investment grade bonds (and sometimes safe-haven government bonds). Conversely, the fund manager is also able to be positioned aggressively through greater exposure to high yield bonds. Such strategies are likely to be highly correlated to the broad credit market, making them more risky than the previous categorisation. A strong fund in this space is the Jupiter Strategic Bond Fund.
While absolute return funds have their own IA sector, there is some merit to considering them within the confines of an investor’s fixed income allocation. The fixed income funds in that sector typically have a low correlation to equity market beta and are primarily focussed on preserving capital values. These low volatility funds produce a Sharpe Ratio of around 1 and are managed to a pre-defined performance target. Furthermore, they broadly maintain some duration in the portfolio, which can provide protection in risk-off periods for markets. One example of a strong fund in this space is the BNYM Absolute Return Bond Fund.
It is clear that the array of strategies in the Strategic Bond sector is wide. At a very simple level some are focused on generating income, while others attempt to generate a total return utilising the full range of securities within fixed income, including derivatives. This means investors should view any allocation to a fund in this sector within the confines of their current portfolio and whether their chosen fund complements their current asset allocation. This brings us to a final word of warning - beware of funds that attempt to benchmark themselves to the wider IA Strategic Bond universe. The vastly different risk-adjusted return profiles of constituents in this space results in shorter-term, quartile performance that can often be a simple reflection of the credit cycle.
Head of Collectives Research and Senior Portfolio Manager
Article first appeared in:
Trustnet (17th January 2017): How Strategic is my bond fund?
Opinions, interpretations and conclusions expressed in this document represent our judgement as of this date and are subject to change. Furthermore, the content is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or a solicitation to buy or sell any securities or to adopt any investment strategy.
Thomas Miller Investment is the trading name of the businesses in the Thomas Miller Investment Group. This note has been issued by Thomas Miller Wealth Management Limited which is authorised and regulated by the Financial Conduct Authority (Financial Services Register Number 594155) and is a company registered in England, number 08284862