Bond Funds for Your Portfolio

Bonds may not be performing as well as equities, but fixed interest is an important part of a well-diversified portfolio

Marianne Weller 22 November, 2013 | 12:15PM
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Following the US Federal Reserve’s comment in May 2013 that bond purchases could slow down by the end of the year given the improving macroeconomic situation in the US, fixed income markets have seen considerable volatility over recent months.  Government bonds were directly impacted with yields rising and bond markets across the fixed income spectrum experiencing outflows. Between May 22 and October 16 this year, the 10-year UK Treasury yield has rose from 1.9% to 2.8%.  Investment grade corporate bonds which have longer duration profiles and relatively low yields also performed poorly especially in June as their correlation to government bonds has increased in recent years as the search for yield and unconventional monetary policies has pushed spreads lower. High yield bonds have fared better as the asset class' short duration characteristics meant it was less sensitive to a rise in interest rates.

Whilst bond markets have steadied to a certain extent over the third quarter, the consensus view is for bond yields to rise gradually even though interest rate rises may be a long way off in the US.  In addition, other major economies such as the UK and Europe are still in a fragile state and the Bank of England and European Central Bank have not altered their stance and continue to maintain an accommodative monetary policy.  Indeed, a number of managers we talk to have highlighted that it has been hard to call the direction of government yields and bond prices this year and expect markets to remain volatile. Against this backdrop, investors are unsurprisingly concerned about their allocation to fixed income.  In this environment, a more flexible approach to fixed income investing may be needed and Strategic Bond funds could have an increasingly important role to play in an investor’s portfolio.

The Sterling Strategic Bond sector only came into existence in 2008 growing out of the Other Bond category.  The sector’s definition is very loose with the only requirement being that "funds must invest at least 80% of their assets in Sterling denominated (or hedged back to Sterling) fixed income securities".  Strategic bond funds have the flexibility to invest globally across the different fixed income markets including government bonds, investment grade, high yield bonds and emerging markets debt.  In markets that have become more sophisticated with an increasing use of derivatives, these funds offer actively managed fixed income exposure.  A key feature of the sector is the fact that they can actively manage their duration.  Managers use derivatives such as interest rate and government bond futures to try and manage the fund's overall duration.

Given the view that rates may rise in the future the flexibility to move to a zero duration position could prove helpful.  Indeed, a number of the many managers that we speak to have been using these enhanced powers to adjust the interest rate sensitivity of their funds and have moved to very short duration positions; these positions have been increased of late.

Which Funds Deliver?

Funds in the Strategic Bond sector can vary considerably, making it difficult to compare funds.  Furthermore, funds in the sector can have varied investment return objectives, for example some funds aim to achieve a return against a particular bond index while other funds have more of a total return focus with no benchmark, looking rather to provide a positive return over cash.  At Morningstar OBSR, we believe that an experienced management team is of utmost importance given the funds’ flexible mandates and broad investment universes.  As a result, our top sector picks tend to be run by veteran managers who have accumulated a wealth of experience over their career managing traditional fixed income funds and benefit from extensive support. We are also mindful that the sector is heavily polarised with the top ten funds accounting for around three quarters of the assets.

The Silver rated M&G Optimal Income fund has been managed by Richard Woolnough since its launch in 2006 on the back of Mr Woolnough’s successful track record of running the Old Mutual and M&G Corporate bond funds.  The fund is the largest fund in the £ Strategic Bond sector, with over £15 billion in assets, due to the manager’s strong macroeconomic assessment and his ability to navigate fixed income markets. We continue to monitor the fund’s size but we believe the investment process is scalable and that the fund size is justified by the wider investment opportunity set. 

Another interesting fund is the Silver rated Fidelity Strategic Bond fund managed by experienced fixed income practitioner Ian Spreadbury.  The manager believes in the merits of diversification and seeks out a wide variety of alpha sources to generate consistent and attractive relative performance over the long-term, which are in line with his macro views.  His more conservative approach has been beneficial in times of market stress and has provided attractive long-term risk adjusted returns for investors.

There are a number of small funds in the universe that are managed by established and experienced teams. The Silver rated Kames Strategic Bond fund stands out as a strong offering, co-managed by David Roberts and Phil Milburn. Their approach incorporates a strong focus on macroeconomics combined with in-depth credit analysis to build a concentrated portfolio of their best ideas. The managers are experienced fixed income practitioners who have used the fund’s flexible mandate to navigate it through changing market conditions and have delivered attractive long-term returns.

In addition, we would highlight the Bronze rated JP Morgan Strategic Bond fund, which has adopted a slightly different approach in that the fund aims to deliver a positive total return ahead of cash by 3% in the medium term.  The fund is co-managed by Bob Michele and Nick Gartside; they are supported by the wider fixed income teams which they are able to use in making absolute and relative value judgements on the different parts of the fixed income universe to construct a portfolio of best ideas.  Investors should be aware that this approach can result in an outcome that is different from established benchmarks.

This article originally appeared in Professional Adviser Magazine

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
Rating
Fidelity Strategic Bond27.64 GBP0.25Rating
M&G Optimal Income GBP A Acc237.09 GBP0.35Rating

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Marianne Weller  

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