Should You Consider a Strategic Bond Fund?

Strategic bond funds have the flexibility to adapt to difficult macroeconomic conditions and allocate assets accordingly

Karine Glauser 27 March, 2013 | 6:19PM
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Demand for fixed income assets has remained strong, fuelled by the search for yield which has pushed investors into higher risk areas of the market such as high yield bonds and emerging market debt in recent months.

Whilst the past few years have seen unusually strong performance from fixed income assets fuelled by liquidity and spread compression, 2013 could see a normalisation of these returns as income once again makes up most of the returns. Indeed, the starting point in 2013 is very different from 2012: government bond yields have reached new lows in all major developed markets whilst corporate bond spreads have also moved in from their 2012 levels.

The search for yield combined with unconventional monetary policies has pushed spreads lower, increasing the correlation of corporate bonds with government bonds, and therefore their interest rate sensitivity. There are also early signs of a recovery in the US housing market which could help produce self-sustaining growth that would push the unemployment rate below the 6.5% target set by the Federal Reserve (FED) earlier than expected; this could precipitate talks of a rate rise as early as 2014, which would have disastrous consequences for government bond markets around the world.

Against this backdrop, strategic bond funds may have an increasingly important role to play within an investor's portfolio. In a difficult macroeconomic environment for bonds, such funds’ flexibility and ability to allocate within the different areas of fixed income markets – including government bonds, investment grade, high yield bonds and emerging market debt – on a global basis is particularly appealing.

As markets have become more sophisticated with an increasing use of derivatives, these funds offer actively-managed exposure to fixed income exposure. Another key feature of strategic bond funds is their ability to manage duration actively. Fund managers use derivatives such as Credit Default Swaps (CDS) and government bond futures to manage their funds’ overall duration position. Many can also achieve a negative duration position, which would be particularly helpful in a context of rising interest rates as these funds would benefit from rate rises and deliver positive returns unlike more traditional fixed income funds. As fund managers are becoming increasingly concerned about current government bond yields levels and the not-so-remote prospect of yield rises, they have been using their funds’ enhanced powers to achieve very short duration positions; these positions have been increased lately and could become outright negative if yields started to pick up significantly.

The IMA £ Strategic Bond sector has been gaining ground of late, and is now the second largest IMA sector after the IMA Corporate Bond sector, with over £42 billion of assets. The sector is heavily polarized, with the top 10 funds accounting for three quarters of assets. In addition, not all strategic bond funds are the same. At Morningstar OBSR, we believe that an experienced management team is of utmost importance given these funds’ flexible mandates and broad investment universes. As a result, our top-rated funds tend to be run by veteran managers who have accumulated a wealth of experience over their career managing traditional fixed income funds and who benefit from extensive support.

The M&G Optimal Income fund, managed by Richard Woolnough, illustrates this perfectly: the fund was launched in 2006 on the back of Woolnough’s successful track record at running the Old Mutual and M&G corporate bond funds and has grown to become the largest strategic bond fund in the IMA £ Strategic Bond sector, with over £11 billion in assets under management, thanks to the manager’s strong macro insights and his ability to navigate fixed income markets. Whilst we continue to monitor the fund size closely, we believe that the investment process is scalable and that the larger fund size is justified by the wider opportunity set. The fund is rated Silver by Morningstar OBSR analyst.

We also particularly like Fidelity Strategic Bond fund which is managed by skilled fixed income practitioner Ian Spreadbury. The manager has built a very strong record at flexing the fund’s allocation in line with his macro views and in response to quickly changing market conditions, with an objective of achieving strong risk-adjusted returns over a full cycle. In addition, his more conservative approach has proved beneficial in times of market stress and has provided attractive long-term, risk-adjusted returns for investors. The fund is also rated Silver at Morningstar OBSR.

Within the smaller funds in the sector, the Kames Strategic Bond fund stands out as a strong candidate. Co-managers David Roberts and Phil Milburn, who are supported by the wider team of fixed income managers at Kames, have implemented a comprehensive process which combines top-down inputs with in-depth credit research in order to build a concentrated portfolio of their best ideas. In addition, the fund’s smaller size allows them to change the fund’s positioning quickly and take tactical positions when opportunities arise. Morningstar OBSR rates the fund Silver.

Finally, we would like to highlight the Cazenove Strategic Bond fund, which has adopted a slightly different investment approach since its launch in 2006. Unlike many strategic bond funds that aim to deliver attractive returns over a full cycle, the fund focuses on adding value via security selection within the BBB to B credit space, where manager Peter Harvey is able to find attractive opportunities. Bottom-up security selection is coupled with a structurally low duration position, as the manager wants to limit the fund’s interest rate sensitivity relative to sovereign bond yields. This approach can be particularly appealing to investors looking to benefit from further outperformance from high-yielding credit. Morningstar OBSR analysts rate this fund Bronze.

For Morningstar OBSR analysts’ take on Cazenove funds in light of the Schroders takeover, click here.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Fidelity Strategic Bond27.64 GBP0.25Rating
M&G Optimal Income GBP A Inc136.45 GBP0.35Rating
Schroder Strategic Credit C Inc0.85 GBP0.13Rating

About Author

Karine Glauser  is a fund analyst with Morningstar OBSR.

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