Tuesday March 5 signals the 10-year anniversary of UK interest rates reaching a rock-bottom 0.5% and the introduction of quantitative easing. This extraordinary loosening of monetary policy has generally been seen as a tide that has lifted all boats.
Over 2018, though, this policy begun to reverse. The US Federal Reserve hiked interest rates four times and reduced its bloated balance sheet by $368 billion, or 8.3%, last year. Until December, it was expected to continue this trend through the course of this year.
However, the Fed became notably more dovish at the end of 2018 and backed that up at its January meeting. Now, futures markets are pricing in zero rate rises in 2019; cuts could follow in 2020.
Elsewhere, the Bank of England’s hand is stayed thanks to Brexit uncertainty and the European Central Bank has recession-related worries of its own to contend with.
Analyst opinion is still split, though. “The market genuinely has no idea what [central banks] are doing going forward,” says Kelly Prior, investment manager in BMO GAM’s multi-manager team.
Monetary policy, therefore, looks uncertain going forward. That means the environment for fixed income is uncertain, too. This puts investors in a quandary.
Bonds are the traditional diversifier to equities and that still seems to be the case despite alternative assets becoming more popular.
In such uncertain times, though, how can investors capture the best possible returns from the bond portfolio of their portfolios? In recent years, fund selectors have advocated allocations to strategic bond funds.
Retail investors, too, caught the strategic bond bug. Between January 2017 and June 2018, funds in the Investment Association £ Strategic Bond sector saw inflows of almost £10 billion, according to Morningstar Direct data.
What Are Strategic Bonds Funds?
Strategic, or unconstrained, bond funds give their managers carte blanche to allocate their cash wherever in the fixed income universe they see the best returns, rather than focusing just one asset class.
In years gone by, says Prior, these funds failed to live up to investor expectations. “They didn’t really move around the asset classes as much as the title suggested they should have done,” she explains.
For many, that criticism no longer seems relevant. Of course, there will always be some that fail, but by and large, “in more recent years we have seen the development of truer strategic funds”.
That’s important, says David Lewis, a manager on Jupiter’s Merlin range of funds, “because the fixed interest world is a huge universe”. It’s not just different asset classes these managers can move through; it’s across yield curves, duration, term premia and currency exposures, too.
“Therefore, there is a great opportunity to try to make returns in the good times but also try to defend capital successfully in the more challenging times,” Lewis adds.
Lewis says his portfolios are almost exclusively invested in strategic bonds and have been for some years now. That speaks to the funds’ positioning becoming more conservative in all areas.
“We’re not outright defensive, but we aren’t aggressive in wanting to take dedicated exposure to things like emerging market or high-yield bonds,” he explains. “Instead we’re taking a step in the more conservative direction by investing in these go-anywhere strategies.”
Fund Picks From the Experts
After an unusually mundane 2017, volatility is on the rise again, as evidenced by significant market falls in February 2018 and then the fourth-quarter of 2018.
With this in mind, Prior says she want to find managers that are much closer to the market than she is. “Managers that can actually spot these changes as they’re happening and position [accordingly].”
For Dean Cheeseman, a member of Janus Henderson’s UK-based multi-asset team, the fact that we’re late cycle and volatility is elevated means we should now be in an environment more conducive to active managers.
As a result, for the past six months he’s been looking to find “proven stock pickers and asset allocators” within the strategic bond sector.
Retail investors seem to have gone cold on the sector. Between September 2018 and January 2019, we’ve seen £4.4 billion of net outflows from the sector. But it still seems a fertile area for investors to be looking at.
When putting together the strategic bond portion of an investor’s portfolio, it’s important to understand the skill set of each fund manager. “Knowing what you’re buying is absolutely vital within this space,” says Lewis.
“Just looking at the name on the tin doesn’t necessarily tell you what you’re buying. Just because it says ‘strategic bond’ doesn’t mean it’s the same as the next strategic bond fund in the queue.”
Lewis says it’s also important to find managers who stick true to what they do best: “The last thing we want is for a manager to start doing things that are outwith their comfort zone and potentially to the detriment of their unitholders."
Janus Henderson Strategic Bond
The Morningstar Silver-rated Janus Henderson Strategic Bond fund is used by both Janus Henderson and BMO.
Nick Watson, who also works within Janus Henderson’s UK-based multi-asset team, says managers John Pattullo and Jenna Barnard have built “a fantastic franchise”. Indeed, Pattullo has been in charge for almost 20 years, while Barnard begun working on the fund 15 years ago and was made co-manager in 2006.
Morningstar analyst Ashis Dash notes that while the pair have a long and solid history of working together, they also benefit from a strong London-based credit team as well as Janus’s resources in Denver. Dash says this is “beneficial for a global, flexible mandate”.
Prior adds that they are “very good at managing duration” in the portfolio and have proven they have the ability to move around the different asset classes “quite considerably”.
Jupiter Strategic Bond
Another Silver-rated offering, Ariel Bezalel’s £3.65 billion Jupiter Strategic Bond fund, is held in the Jupiter Merlin mandates. Lewis says it’s the most flexible strategy his team uses.
The fund was launched 11 years ago as a credit selection portfolio, he explains, but is now more driven by macro-economic factors. Currently, almost half the portfolio is invested in sovereign bonds.
The capital preservation features of these high-quality Government bonds is well balanced using a barbell approach to portfolio construction with the income-generation of high-yield debt, adds Morningstar analyst Irene Ruiz Espejo.
“Bezalel’s active management of these exposures as well as duration has added value over the years,” she adds. “Opportunistic exposure to select emerging markets has been an additional contributor.”
Pimco Income
Managed by Alfred Murata, the mammoth $60 billion Silver-rated Pimco Income fund is liked by Watson, though both he and Cheeseman note some concerns about the fund’s size.
Morningstar analyst Mara Dobrescu says the fund “boasts a world-class team, process and performance record”. Murata formerly ran the firm’s structured products portfolios and now heads its asset-backed securities team.
Combine this with the Pimco’s large group of mortgage and real estate specialists and the team has the ability to go pretty much anywhere.
Watson describes the Pimco fund as “very steady and very boring” and prefers to combine it with the more risk-seeking TwentyFour Dynamic Bond fund. “They’ve both outperformed the sector over the long run, but in completely different ways.”
The TwentyFour fund has more exposure to financials and European high-yield, he explains. It’s a team Lewis, who says they are skilled credit-pickers, also likes.
Legg Mason Western Assets Macro Opportunities
Prior likes the “punchy” Bronze-rated Legg Mason Western Assets Macro Opportunities Bond fund, led from the US by seasoned investor Ken Leech.
Prior explains that the fund looks for “relative value trades”, for example trying to find price dislocations in the German market versus the US market. The team overlays their longer-term, value-driven themes, Dash adds, with short-term, tactical macro strategies.
They will use a wide range of positions, including emerging market bonds, rates and use currency markets, as well as a core base in more traditional assets.
