Not the only fruit

Demand for strategic bond funds has rocketed as advisers seek multi-asset ­exposure. However, no two funds are the same, despite being lumped into one sector, which poses many challenges, writes Muriel Oatham.

Strategic bond funds have surged in popularity this year, with the sector leading retail fund sales in April, May and October. However, while performance has been strong – with the sector returning an average 37.6% over the past three years, according to Morningstar – it is the flexible nature of the funds that advisers are keen on.

“Until strategic bond funds were launched, from an asset allocation perspective, you had to make your own calls,” says James Calder, the head of research at City Asset Management. “Now you can pick a bond manager with good asset allocation skills.”

Adrian Gough, the head of investment management at RSM Tenon, agrees. “Strategic bond exposure gives us managers who have the skill to do what we cannot, moving between asset classes and credit spaces. These managers can make calls in the fixed interest market that we cannot.”

Tim Cockerill, the head of collectives research at Rowan Dartington, likes the opportunity for investors with limited assets. “One good strategic bond fund can give pretty comprehensive exposure to fixed income investment,” he says.

And Damien Fahy, the head of research at Dennehy Weller, says the economic climate is driving fund sales. “Advisers pick these funds as a solution in uncertain times.”

However, because strategic bond funds are marked as go anywhere, multi-asset bond funds, selecting a portfolio is not a straightforward task. A closer look shows just because the funds are in the same sector, few are the same. (Cover story continues below)

“Strategic bond is not a homogenous sector,” says James Davies, a portfolio manager and fund research specialist at Close Asset Management. “Funds range from ’plain vanilla’ strategies holding government and corporate debt through to those heavily invested in high yield and emerging markets.”

Fahy agrees the diverse sector challenges advisers. “Strategic bond is such a wide sector. No two funds are the same. Investors need to understand what is driving performance and recognise that there are hidden risks.”

Cockerill also notes how much the sector has changed. since the first funds were launched. “A few years ago, it was pretty clear-cut: funds with asset allocations between investment grade and sub-investment grade bonds, with parameters for minimum and maximum exposure.

“But it has become fragmented. The top performers over the last six months include long-dated, inflation-linked bond funds. They are different to a traditional strategic bond fund. So it is an added complication for investors.”

Stephen Walker, the head of research at Ashcourt Rowan, says flexible asset allocation poses a risk for investors.

“The return profile [of strategic bond funds] is between investment grade and high yield. So why bother? It is not too difficult to buy a specialist fund. If you like to know what you are investing in, you are introducing an extra margin of error.”

Fahy agrees that the investment freedom permitted by the sector can present difficulties.

“For example, many managers are trying to boost returns by going into high yield. But it is highly correlated to the stockmarket, so when the market falls, the funds are exposed.”

Instead Fahy likes conservative investment strategies, such as the Fidelity Strategic Bond fund.

“It is a very defensive strategy. Less high yield exposure does mean lower yield and less income. But its high proportion of investment grade bonds means it has done well, and if government debt prices rise it will benefit.”

Ian Spreadbury, the fund’s manager, says his focus is keeping risk down to “acceptable levels”. His fund aims for “low volatility of returns, a decent level of income and some level of diversification from equities.”

To achieve the latter, high yield exposure is capped at 50%. “This is the only asset allocation restriction on the fund,” says Spreadbury. But his high yield exposure is 20% as he expects default rates to increase.

The bulk of the fund is invested in high-grade investment grade credit. “Sterling corporate non-financial BBB is yielding between 4 and 5%. So by moving from gilts into corporates you are almost doubling the yield.”

He says stock selection is important. “I have been focusing on safer corporates, companies like Tesco and Imperial Tobacco, that will get through a tough and volatile environment.”

And 10% of the fund is invested in inflation-linked bonds. “I think inflation is a tail risk but it does make sense as a portfolio diversifier.”

Fahy also likes the JP Morgan Strategic Bond fund. “It has low exposure to high yield, lots of top-performing high-quality AAA corporate bonds, and exposure to global government debt,” he says.

“The fund has a global remit, so it does include emerging market debt. It moves between asset classes, even into cash. And the yield is not bad, currently 4-4.5%.”

Iain Stealey is a portfolio manager on the fund, which he says is managed to three key principles.

“First, we can only have up to 50% of the fund in high yield. We are not just a super-charged high yield bond fund. High yield is part of our alpha generation, but not the sole source. At times this year, we have owned very little.

“Until strategic bond funds were launched, from an asset allocation perspective, you had to make your own calls”

“Second, we have duration of between 0-9 years. We cannot go negative duration. What I call an absolute return bond fund might have a duration of between -1 and 1 year, but we think a strategic bond fund should have some element of fixed income.”

“And thirdly, we have 80% of the fund in sterling. We use foreign exchange round the edges but we are not a currency fund.”

Stealey says the fund aims to return 3% over cash, net of fees, over a business cycle. “We generate good returns but at a low volatility. Some of our competitors have a lot more risk than us.”

The fund is invested heavily in America, with 30% in high yield and 20% in investment grade debt, both predominantly American. “And we have about 7% in Australian government debt: 10-year bonds yielding 4.5%, effectively double what you are getting from US Treasuries or gilts,” says Stealey.

He makes limited use of financial instruments. “We use government bond futures, exchange-traded, particularly at the moment, to add liquidity. But we are light users of more complex instruments such as credit default swaps (CDSs).”

Juliet Schooling-Latter, the head of research at Chelsea Financial Services, likes those funds with lots of flexibility. “We like ’proper’ strategic bond funds, where the manager has substantial scope to shift between assets, rather than being range bound.”

However, she says this poses a challenge to investors seeking income. “I suspect yield moves around a lot more as the manager moves between asset classes.”

Davies agrees this is a problem for the sector. “A strategic bond fund should be paying out an income,” he says. “But they do vary, from sub-4% through to Henderson Strategic Bond, which invests heavily in high yield and even preference shares, paying over 6%.”

He likes the Kames Capital strategic bond fund, which pays 4.5%. Launched in 2003, this is one of the oldest funds in the sector. “[David] Roberts utilises the whole spectrum of available credit. But he is favouring asset-backed investment.”

Roberts, the joint head of fixed income at Kames Capital, has the flexibility to invest “all or none of the fund in any asset class,” but typically invests 25% in high yield and emerging markets, 40% in investment grade and 35% in government bonds.

“We realised that as soon as we moved much over 30% into high yield, it tended to be a dominant characteristic, and we did not want that. And we like investment grade bonds. Over time, you are well compensated for the level of default risk,” he says.

Investment grade holdings include asset-backed securities, such as BAA, train operators and pub companies. “Classic, sterling-de-nominated, whole-business securitisation where bondholders have title to assets of the business and associated cashflows,” says Roberts.

And he has started to take positions in the American residential mortgage market. “We are buying portfolios where the capital price is 50 cents in the dollar. We do not expect to get 100 back but 60 or 70 is achievable.”

And Roberts uses financial instruments. He limits his non-sterling currency exposure by using currency forwards to hedge foreign exchange exposure back into sterling.

“We use derivatives to control risk, rather than take more of it,” he says. He uses interest rate futures to move duration around, and index-level credit derivatives to protect parts of the portfolio.

“We use iTraxx CDX [credit default swap indices] to provide insurance on the finance sector. About 20% of the portfolio is in banks so we hedge against underperformance.”

“And we have a macroeconomic hedge: protection in America for emerging markets via the CDX index. We do not think emerging markets will be immune from a significant global slowdown. So we have sold the index at 15% of fund’s value.”

Roberts says this derivative protection means he has a lower cash position than many of his competitors. “We believe in being invested. We like to invest the cash and then protect it. We look for alpha in the market but if we are nervous, we will sell the beta.”

Cockerill says a similar approach is taken by Richard Hodges in the L&G Dynamic Bond Trust. He, Gough, Davies and Schooling Latter like the fund, which has returned 53% over the past three years, despite a difficult 2011.

“Hodges uses derivatives to go short, and protect the capital within the fund. This worked to great effect during the credit crunch,” says Cockerill.

Hodges confirms this. “We use futures and interest rate swaps to actively manage the fund’s duration exposures. Using derivatives to do this means we can leave the fund’s underlying exposures broadly untouched.”

And, like Roberts, the manager has protected against his financial holdings. Hodges still likes financials, which he says offer good opportunities for both long-term growth and shorter, more tactical trades.

“But holding around 30% in financials this year means we have had to weather some volatility. We manage this by hedging positions and buying protection, via CDSs, on the same name to minimise credit risk,” says Hodges.

Schooling Latter says the permitted use of money market instruments and equity investment is a further challenge for the sector, “Alongside experience and expertise in credit, strategic bond managers must also be very comfortable using equities and derivatives.

“But the most important thing is to get a manager with a good grasp of macroeconomics, and then allow them to implement those views as they see fit.”

She, Cockerill and Davies all like Richard Woolnough’s M&G Optimal Income fund. This is another strong performer, returning 54% over three years.

“Funds range from ’plain vanilla’ strategies holding government and corporate debt through to those heavily invested in high yield and emerging markets”

“M&G has a conservative approach to fixed income. Even their higher-risk holdings are not that risky. And Woolnough uses a derivative overlay to smooth returns, which helps make the large portfolio efficient,” says Davies.

“And [the fund] is a good income vehicle, paying over 4% while remaining relatively low risk and low volatility.”

Cockerill likes M&G’s ability to maintain an independent view of the world. He says Woolnough’s consistency in avoiding the financial sector, even when banking bonds seemed to offer good value, is impressive.

Woolnough is bearish on the banking sector, expecting volatility to continue. He says he will invest in banks on a case-by-case basis, but reduced the fund’s financials exposure from 14.2% to 13.4%.

However, Fahy warns Woolnough’s use of equities is a hidden risk to investors. “I am not sure everyone understands that when they are buying the fund.”

And Woolnough increased equity exposure in the last quarter, from 5.7% to 8.4% “mostly in blue chip high-yield companies such as big pharmaceutical and oil and gas groups”.

Schooling Latter also likes the Henderson Strategic Bond fund. “John Pattullo is an experienced manager with a great deal of flexibility within his fund,” she says.

Pattullo, the head of retail fixed income at Henderson, says he is “relatively aggressive” in asset allocation. “The fund has to be invested in fixed income. But asset allocation is the driver, not stock selection.”

However, this is challenging. “We pride ourselves on our asset allocation, but with a £1 billion fund, you cannot be a gilt fund one day and a high yield fund the next.

The daily liquidity of the market makes it hard to jump between asset classes.”

He uses interest rate futures to manage interest rate risk and credit derivatives via iTraxx to manage liquidity and to reduce cost. “Conceptually we have two funds: one made up of cash bonds, which are expensive to trade, and one made up of credit derivatives.

“Our turnover of physical bonds is about 20-30% a year, but turnover of derivative overlays is much higher.

“For £100m of iTraxx crossover you can get £15m of credit derivatives of investment grade or high yield bonds, or £3m of cash bonds. The derivatives market has extraordinary liquidity.”

But he says the downside of this is volatility. “The daily turnover in iTraxx crossover in London is €6 billion (£5 billion) of contracts, and can reach €10 billion. The entire European high yield bond market, in cash bonds, is €150 billion.”

However, Pattullo says derivatives are important in managing economic volatility. “There is a perception that strategic bond funds have to asset allocate within the confines and liquidity of the market. But derivatives help you become more efficient. We do move the fund around a lot. Sometimes you get it wrong but you hope that the majority of the time you get it right. But it is a conviction strategy: not index hugging.”

Gough likes the riskier strategic bond funds. “Of the ’proper’ strategic bond funds, there are a subset that are effectively bond hedge funds. Managers can exploit yield, currency and duration.” However, investors must understand this high-conviction approach. “[People think] bond exposure is low risk, but these are high-risk funds,” he says. “You are taking a huge key man bet on each of these funds.”

He manages this risk through diversifying his holdings, with M&G Optimal Income and L&G Dynamic Bond Trust alongside Stewart Cowley’s Old Mutual Global Strategic Bond fund.

“Stewart is fully prepared to reflect his views in the fund. He was short duration early this year. And he takes currency bets. It is a great blend fund.”

Cowley, the head of fixed income at Old Mutual Asset Managers, whose fund sits in the Global Bond sector, says titles are not helpful.

“There is a perception that strategic bond funds have to asset allocate within the confines and liquidity of the market”

His fund makes full use of permitted investment freedom. “We can go positive or negative duration, so we can make money when yields are rising. We can have 50% of the fund in corporate bonds, or none. We can be fully hedged into our base currency, which is sterling, or have under 50% in sterling.”

Cowley says bond managers must use “every tool available to them” to manage price swings, particularly when liquidity is poor and access to cash markets is limited.

“If you are not using derivatives you are not controlling risk, you are just at the whim of the market. And we are seeing massive capital price swings.”

He uses derivatives and CDS at an index level to protect his corporate bond holdings and reduce price volatility.

“We have bought futures instead of buying [bonds] to go negative duration. We have puts on government bond futures, and we can sell a call option and buy puts with the proceeds to stabilise a unit price.”

But he is clear he is not a hedge fund manager and his aim is to protect investors from the threat of inflation. “Investors need a total return fund that is managed for unit price, with a primary objective to beat cash.”

Calder likes similar funds and looks for those that match his firm’s absolute return mentality. “We are less inclined to worry about relative return but we do not want to lose money. So we like funds with a similar aim.”

He says this is particularly important with bond funds. “Bond funds have an asymmetric risk profile. The upside is fairly limited but on the downside you can lose your shirt.”

He likes the Absolute Insight Credit fund, managed by Alex Veroude. “The fund is run on a long/short basis. [Veroude] can take negative calls, use CFDs (contracts for difference), and make duration bets. He really can go anywhere.”

Veroude says he has some restrictions. “The fund is limited to bonds and to credit risk. There is no interest rate or exchange rate risk.”

“But in credit, we have no limits at all. We can use asset-backed loans, high yield, investment grade, financials, emerging market debt, and we use them all.”

He says the fund’s aim – which is not to lose money on a 12-month holding basis – limits strategy. “Absolute return is a more strict discipline within strategic bonds.”

“Nobody is infallible. And the more flexibility they have, the more wrong they can be”

He uses short-dated assets to generate cash and provide protection against downside. “You can get attractive yields of between 10-15% on assets that mature in six to 12 months. And when they mature, you get your cash back. Our investments are staggered to ensure that every month we get a little money back. So our cash balance can rise very rapidly.”

Veroude uses derivatives to manage liquidity, and to create specifically tailored holdings. “If a cash bond has a three-year maturity, you either buy it or you do not. In derivative form, you can buy any maturity.”

“We are indifferent between derivatives and cash bonds. The fund may own the majority of its assets in derivative rather than cash form.”

Veroude says the fund, which is soft-closed, sits “somewhere between the [traditional] strategic bond and the hedge fund sector. Hedge funds run two to three times more risk than we do.”

The opportunity presented by the strategic bond sector is significant with a range of funds catering to every risk appetite. And while outsourcing asset allocation is attractive, advisers recognise that understanding these complex funds is key.

But one risk remains, says Schooling Latter. “The [manager can] get it wrong. Nobody is infallible. And the more flexibility they have, the more wrong they can be.”