What are strategic bond funds?

Strategic Bond Funds could offer a solution in a difficult environment for investors in fixed interest.

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  1. Rob Morgan

Investors in bonds face something of a tightrope walk. If the global economy runs too hot then more defensive investment grade bonds are vulnerable. Their leaner levels of income would offer investors little compensation in an environment of rising inflation and interest rates, and capital values could fall.

On the other hand, adopting a more aggressive stance by using more economically-sensitive areas such as higher-risk high yield  or emerging market bonds in the hope of higher returns would likely result in underperformance if, in the longer term, deflationary forces take over, economic stagnation ensues and company finances deteriorate.

In an uncertain, changeable environment, being able to move between different parts of the bond market is potentially valuable, and investors may wish to consider the use of fund that can do this for them. There are a number of funds in the Investment Association (IA) Sterling Strategic Bond sector that aim to offer a ‘one stop shop’ for fixed interest exposure – and make tactical allocations in order to provide superior performance. Here’s some of the questions we think about when assessing these funds.

 

What does strategic actually mean?

It can be argued that a number of funds in the IA Strategic Bond sector have not really been strategic enough. They may have blended various elements of fixed interest together in a single fund and aimed to generate superior returns within each , but they haven’t actually changed the amounts dedicated to the different areas that much, or on a sufficiently regular basis, to capture additional performance. Ideally, a fund should aim to add value in terms of tactical allocation as well as stock selection, but being good at one or the other can also be beneficial for investors.

 

What is the manager record?

Clearly a record of adding value by tactical allocation can be important when selecting this sort of fund. A lot of strategic bonds funds have struggled in recent years because they have lacked exposure to government bonds, or else had a low level of interest rate sensitivity in an environment of falling yields. Allowing for this, we look for managers who have shown they have added value through their decisions.

 

Is the fund size too large for useful stock selection?

It’s harder to be strategic with a large fund. It can still be successful with the right long term thinking but it is difficult to make a sudden changes of tack. Stock selection also becomes an issue. Large funds have to be diverse because they can’t own any single bond issue in a significant enough proportion to make a real difference to performance. The other tools such as interest rate sensitivity and strategic allocation to various parts of the bond market remain ways to add value, but it is smaller, more nimble funds that might add value in a more meaningful way through stock selection.

 

Is it worth the fees?

Charges are really important when it comes to bond funds as they typically produce lower returns than equity funds, so charges can eat up a greater proportion of returns. Thus we need to have a high level of conviction in order to back an active manager over a mix of passive funds that offer very good value.

For instance, Legal & General Sterling Corporate Bond Index Fund has ongoing charges of just 0.14% a year. There is also a short dated corporate bond fund from the same provider.  The yield on offer may be less attractive, but it should be less sensitive to the direction of interest rates if this is of concern to an investor, and it means overall volatility is likely to be lower.

 

Some fund options in the Strategic Bond sector

Aviva Strategic Bond is an agile fixed interest fund with a high-conviction approach. The fund is also modest in size compared with many of its peers, which affords the manager, Chris Higham, a high degree of flexibility and the chance to fully capitalise on the significant resources available to him at Aviva.

We would expect Mr Higham to have greater scope than to switch the portfolio around in a timely fashion than many competitors, and to be able to successfully run a more focused stock-picking portfolio of 80 to 100 holdings. Larger funds in the sector typically have many times this number of positions. The manager has shown willingness to actively manage the fund’s exposure to various parts of the fixed interest market and to alter interest rate sensitivity.

Recent performance has been a little disappointing. The fund is much less interest rate sensitive than many other bond funds and this has been a considerable impediment in an environment of falling interest rate expectations. However, with this stance we would expect it to offer some resilience versus others if inflation and interest rates rise.

Janus Henderson Strategic Bond Fund’s unconstrained approach allows the managers, John Patullo and Jenna Barnard, to take strategic decisions between countries, sectors and various credit ratings. In our view, this flexibility combined with the depth of resource and experience of the managers affords the chance for good long term performance.

The fund has been a consistently strong performer in recent years – although past performance is not a guide to the future. The managers believe there are structural deflationary pressures at work in global developed markets, and view guides much of their positioning – a bias to government and other high quality bonds with the aim of balancing the need for income with a desire for capital preservation. This results a lower yield.  It also means the fund is quite interest rate sensitive; rising rates globally would be at odds with the managers’ current views and detrimental to fund performance. It’s much larger than the Aviva fund so opportunities to add value through stock selection may be more limited.

 

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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