Isa ideas: is there a case to be made for strategic bonds?

14th February 2014

The fixed interest bull run may be coming to an end. Many are predicting rising interest rates, but perhaps not in the immediate term. Is there still a case for investing in the strategic bond sector? Investment journalist Cherry Reynard examines the issues.

What is in the strategic bond sector?

Fixed income appears to be drawing to the close of a 10 year bull run. Having fallen progressively since the credit crisis, base rates now look to be on the verge of turning as economic growth improves. This has left many fixed income investors with a dilemma:

Stick to ‘safe’ bonds such as developed market government bonds and adjust to low yields? Or take risk on corporate bonds, which offer higher income, but are still expensive after a lengthy period of strong performance? Or should investors be delving into more illiquid and adventurous parts of the fixed income market, such as floating rate notes?

A strategic bond manager will make these decisions for an investor. Strategic bond funds provide the flexibility for managers to move into different areas of the bond market depending on where they see most value. At any point, a strategic bond manager, may have a high weighting to gilts, or high yield, or more complex parts of the bond market, wherever they believe offers the best balance of risk and reward.

Range of fund strategies within sector?

The definition of the sector is its flexibility, so there is no uniformity of approach between the different funds. That said, the sector splits evenly into those funds that aim to offer an income and those that don’t. The top fund in the sector (the Royal London Sterling Extra Yield fund) has paid an historic income of over 6.5%. However, around one-third of the funds in the sector pays an income of less than 3% and some pay none at all. Income seekers need to ensure that they select a fund targeting a higher income.

Funds will also differ in the amount of risk they take. Some funds will focus on developed market government bonds with the aim of keeping risk lower. Others will move further into corporate bonds, both investment grade and higher risk ‘high yield’ bonds, with the aim of generating a greater income or stronger capital return, but this approach will come with higher risk. Some will focus on shorter-dated bonds, which are less interest rate sensitive, other will aim to offer more of a mix. Funds will also vary on the amount of their portfolios they hold in the UK. The M&G Optimal Income fund, one of the most popular funds in the sector, is around 50% weighted to the UK, while the Axa Sterling Strategic Bond fund has a near 100% weighting, and the BNY Mellon Global Strategic Bond fund an 8% weighting.

Recent performance?

Over the past five years, the average fund in the Strategic bond sector has grown by 60.7% (to 12th February). This compares to average growth from the UK Gilts sector of 21%, from the UK Sterling Corporate bond sector of 52.4% and from the Sterling High Yield sector of 96.2%.

By far the best performing funds over the past one, three and five years have been those with a high yield bias, or with a bias to riskier areas such as banks. Managers who have rightly concluded that in an improving economic climate is likely to favour higher risk bonds have done well, while those who have stuck with government bonds have fared less well after the asset class sold off last year, in response to the tapering of quantitative easing.

The top-performing fund in the sector – the Royal London Sterling Extra Yield Bond fund has returned 133.8% over the past five years, one of six funds in the sector to deliver over 100%. In contrast, the Pimco GIS UK Sterling Low Average Duration fund has delivered less than 20% over the same period.

When does it perform well/badly?

Funds within the strategic bond sector should have the flexibility to perform in all market conditions. However, bond funds will always struggle at times of significant economic expansion and rising interest rates. Strategic bonds funds may offer greater protection during inflationary times if the manager their positioning right, but may not be able to protect capital in all market climates.

What sort of investor does it suit?

Strategic bond funds suit investors who would rather not try to make the decision on whether they are in government or corporate bonds, whether they should be in long or short dated bonds and how much risk they should be taking. It should suit those investors who want a ‘one stop shop’ for their fixed income exposure. Some strategic bond funds are also suitable for income seekers.

How much of a portfolio for low/mid/high risk investor?

Strategic bond funds are a natural core holding for fixed income investors, but investors cannot guarantee what the manager will be holding at any one time. Therefore an investor who is keen to have an exposure to lower risk government bonds to balance a high stock market exposure, for example, may be better off in a conventional government bond fund. However, investors in strategic bond funds have the reassurance that they will be invested in whichever fixed income securities the manager sees as providing the best value at that time in the cycle.

The popular funds

Top 10 by performance (5 year) – Strategic Bond sector

Royal London Sterling Extra Yield Bond

AXA Framlington Managed Income

Old Mutual Monthly Income Bond

Invesco Perp Monthly Income Plus

Artemis High Income

Baillie Gifford Corporate Bond

 

Jupiter Strategic Bond

SJP Corporate Bond

F&C Extra Income Bond

Aviva Inv Managed High Income

 

Questions investors should ask

– Do I want to generate an income?

– Do I want a manager who keeps a balance in certain assets, or a true ‘go anywhere’ fund?

– Do I want a manager who invests globally or just in the UK?

– Am I comfortable with a manager who invests in high yield and banking bonds?

– Do I want to invest with a large fund group, or with a boutique group?

 

Adviser views

Damien Fahy, head of research, FundExpert.co.uk

“Strategic Bond fund flexibility has its attractions but added flexibility does not guarantee positive performance. The reality is that a wider investment remit gives a fund manager greater scope to get things horribly wrong. A quick glance through the current best and worst performing strategic bond funds shows a wide range of returns. In the last six months investors who got it right would have been rewarded with a return of over 9%, those who got it wrong lost money. The sector is not a homogenous group of funds but rather an eclectic mix of different investment strategies.”

“We usually hesitate before wholeheartedly recommending strategic bond funds, typically preferring to have control over our bond exposure by using focused funds. However Artemis Strategic Bond, continues to perform strongly benefiting from astute calls around the Federal Reserve’s tapering of its money printing programme.”

 

Patrick Connolly, financial planner, Chase de Vere

“Most investors should hold fixed interest in their portfolios and strategic bond funds are our preferred method to get this exposure. Within these funds, managers have the flexibility to asset allocate between different fixed interest investments which means they can diversify risks and hopefully find the best opportunities and avoid the most expensive areas

“However, with Strategic Bonds there can be vast differences in how funds are constructed and run. This is evidenced in current fund yields ranging from 1.9% to 6.8% and performance over the past year from -2.6% to +13.1%. It is important to understand how individual funds work, rather than assuming that all funds in the sector are broadly similar.”

Fund recommendations: Jupiter Strategic Bond, Kames Strategic Bond

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