The IA Sterling Strategic Bond sector is home to a range of different fixed income funds that seek to deliver a variety of investment outcomes. The only requirement for inclusion in the sector is a minimum exposure of 80% to fixed income assets denominated in sterling (or hedged in sterling).
Funds in the sector may follow various investment guidelines. They include different geographic and sector biases, varying exposures to interest rate and credit risk, and range from developed government bonds to high yield corporate bonds, and even equities.
Additionally, there is no common benchmark against which funds can be measured, and since fund asset allocations can change significantly over time, any meaningful comparison between strategies is difficult.
A part of it all
To address this issue, we at Square Mile have divided the sector into four sub-sectors, so that more meaningful comparisons can be made from a performance and risk perspective.
The first three of our four categories score different points along a traditional risk spectrum. As an investor moves from one category to another, it is expected that the additional volatility incurred will be rewarded with a higher return over time.
The two categories at the lower end of the risk spectrum, low-risk and medium-risk, are multi-sector, meaning they can hold a mix of investment-grade fixed income assets, government debt, high yield, emerging market debt, asset-backed securities and inflation-linked bonds with a moderate overall component of duration risk.
Funds within these two groups are likely to form the traditional defensive component of a bond allocation. The third, higher-risk group includes funds that are primarily credit-oriented and have a closer correlation to broader markets.
The fourth category, duration risk, reflects the need for the most traditional component of a fixed income allocation: diversification. The funds here take an active asset allocation approach, but will generally have significant duration risk, providing the level of diversification that investors seek from a fixed income allocation.
When economies are struggling and stock markets are underperforming, central banks should typically cut interest rates, which results in positive returns for duration risk. At this point, these types of strategies usually provide some counterweight to larger market losses.
In terms of our expected results for each sub-category, funds in the low risk group will focus on capital preservation with some income, medium risk funds will aim to provide income or a combination of accumulation of capital and income, higher risk funds will be income oriented, while duration risk funds should provide a combination of capital accumulation and income.
Essentially, our creation of the four sub-categories reflects the need to determine what outcome an investor can expect from a fund within the industry, determine its objective, and consider what benchmark can be set to demonstrate success .
Limitations may arise due to the flexibility of parameters that govern funds and exposures changing over time, but by establishing the sub-categories, an informed decision on fund selection can be made based on a comparable comparison More reliable.
A hard road
The past few months have been one of the worst times on record for fixed income, with significant negative returns across all asset classes, from government bonds to investment grade corporate bonds, to high yield and emerging market debt.
After years of loose monetary and fiscal policies, major Western central banks have adopted tighter monetary policy in response to high levels of inflation. Interest rates were raised as banks sought to reduce some of the stimulus and liquidity injected into the market after the global financial crisis.
This was extremely painful for existing assets in government bonds. Additionally, credit spreads also suffered from weakening economic data and the uncertainty of the war in Ukraine.
turn the corner
In such an environment, strategic bond funds have struggled to provide the stable returns and diversification characteristics that investors have come to expect. Large losses have been the norm and are of similar magnitude across different asset subclasses. Only the least risky funds, with a focus on capital preservation and structurally lower exposure to interest rate and credit risk, were able to mitigate losses.
However, the circumstances are now different, as the world has moved on. First, interest rates have risen significantly, providing a larger cushion to protect capital if we see further upward moves in rates.
Second, if we enter a recessionary scenario, as many fear, central banks are unlikely to maintain their hawkish interest rate policy. Indeed, many flex bond managers have already increased their interest rate exposure as they anticipate a reversal of recent yield increases.
As markets adjust to the new environment of inflation and higher yields, we believe that fixed income assets (in general) and strategic bond funds (in particular), given their flexibility to adapt market conditions, are in fact now in a stronger position to regain their role in portfolio diversification.
FUNDS TO WATCH: PERFORMANCE OVER 3 YEARS
1. After the departure of his co-manager last year, Mike Riddell quickly reinforced the Allianz Strategic Bond team made up of three senior recruits who brought a wealth of experience. After outstanding returns in 2020, the fund was challenged by a short UK inflation position last year, with returns more in line with the sector so far in 2022. A major attribute is the the fund’s low correlation with equities.
2. Aegon Strategic Bond Senior Portfolio Managers since late 2018, Alex Pelteshki and Colin Finlayson bring together complementary skills in credit and macroeconomics. While maintaining the fund’s longstanding investment process, they were more active than previous managers and demonstrated a higher level of conviction when expressing their opinions. This, so far, has been rewarded with better performance than their predecessors.
3. Despite the retirement of Invesco Tactical Bond Paul Read and Paul Causer at the end of 2021, Stewart Edwards and Julien Eberhardt, longtime members of Invesco’s fixed income team, continue the success of this flexible, value-oriented, high-conviction fixed income strategy. This fund has stood out in recent years thanks to its low volatility and its defensive profile focused on downside protection.
FUNDS TO WATCH: NEW ARRIVALS
1. Invesco Environmental Climate Opportunities is co-managed by Mike Matthews, new co-head of fixed income at Invesco, and Tom Hemmant, manager of corporate bond strategies. This newly launched strategy has a dual mandate to deliver financial returns and support the transition to a low carbon economy. The portfolio is credit oriented, combining high quality corporate bonds with high yields. In the first few months, the fund’s returns were closely aligned with those of the Invesco corporate bond fund, managed by the same team.
2. Since joining the firm in 2020, Premier Miton Strategic Monthly Income Bond Managers Lloyd Harris and Simon Prior have continued the focused, high quality approach they used in their previous house, combining investment grade, financial and subordinated debt. Their focus on short maturities and low volatility income generation works well in today’s rising interest rate environment.
3. A high income strategy, NB Global Flexible Credit was launched in Ucits format in January 2020. However, the team has been running the strategy for over 10 years for institutional accounts, so they have a long track record behind them. The fund invests with a ‘one size fits all’ approach in credit assets, backed by the firm’s global resources.
FUND TO WATCH: ASSETS UNDER MANAGEMENT
1. having succeeded Strategic Bond Janus Henderson Together for nearly 20 years, John Pattullo and Jenna Barnard have demonstrated the market savvy and agility to consistently deliver strong risk-adjusted returns in the industry. Their willingness in recent years to overweight duration, despite low global interest rates, has been a distinguishing feature that has been particularly rewarding for the strategy. However, this has been a headwind for the fund in recent months.
2. The TwentyFour Dynamic Bond is managed by an experienced team backed by the strong credit resources of a dedicated fixed income investment boutique. Despite the flexible allocation approach, designed to take advantage of opportunities in the fixed income universe, there is a structural bias in favor of financial subordinated debt, where managers have found attractive opportunities, and which represents an essential part of the portfolio.
3. M&G UK Inflation Linked Corporate Bond is one of the most defensive options in the conservative sub-sector, with the fund offering one of the lowest volatility and downside risks. Using three levers to generate returns – inflation, rates and credit – Ben Lord focuses on capital preservation. This has allowed the fund to stand out as one of the few to protect capital in the recent environment of rising interest rates.
Eduardo Sanchez is Head of Fixed Income and Absolute Return at Square Mile Research
This article first appeared in the July edition of Portfolio Adviser Magazine