We need to talk about strategic bond funds’ strategy

Strategic bond funds are a real mixed bag, and even the recent top performers have found value in different places.

Investment flexibility is a huge boon, but only when it is used wisely. ‘Go anywhere’ strategic bond fund managers excelled prior to 2018, riding the tail of the 35-year bond bull market, but the return of volatility last year – one of few tests since the 2008 financial crisis – proved challenging for some.

Pimco GIS Income is the frontrunner in the IA sterling strategic bond sector over the past year, having made 11.2%, while the weakest performer, Man GLG Strategic Bond, has lost 3.1%.

“A more than 14% difference in 12 months is huge in a seemingly less volatile asset class that investors perceive as ‘safer’,” says Ben Yearsley, a director of Plymouth-based Shore Financial Planning. “That alone tells you there’s a huge difference between how managers are positioned and how they run their funds.”

Broad remit

The remit of the sector is very broad. The only requirement is that a fund must have 80% of its assets in sterling-denominated bonds or those hedged back to sterling. That means managers are able to invest anywhere in the world and across the fixed income spectrum.

At the more cautious end are government bonds, also known as gilts in the UK, T-bills in the US or treasuries the world over; at the riskier end are emerging market debt, high-yield bonds (also known as junk bonds due to their lower credit ratings) and convertible bonds, which pay interest like a traditional bond but can be converted from a company’s debt to its equities at certain times during the term. In the middle of the risk spectrum sit investment-grade bonds (rated BBB or higher).

“The outlook for fixed income isn’t overly positive – we are in the late stages of the economic cycle and bonds have enjoyed a multi-decade bull market – but for good managers who can invest in any type of bond there will always be opportunities,” says Darius McDermott, managing director of FundCalibre. But the problem with many strategic bond funds, according to Yearsley, is that managers haven’t used the full flexibility on offer: “Just because the sector rules say you can do something doesn’t give each fund manager the same flexibility; they all have their own specific mandate and approach.”

Between 2015 and the start of 2018, all of Shore’s clients’ bond exposure was to strategic bond funds. Today, up to one quarter is in global bond funds, which have a number of levers at their disposal, including the currency in which holdings are denominated.

“With so much uncertainty about rates [during those years], putting all of our bond exposure into strategic bond funds seemed like the obvious thing to do: let the managers decide where the best opportunities are in the bond world from gilts to junk bonds,” says Yearsley. “The problem with that approach is that you’re relying on the managers to make the right calls – and they haven’t always done so.”

Recent calls that have proved auspicious for investors include Pimco’s de-risking in 2016 and 2017, which enabled it to buy attractive assets, like mortgage-backed securities, at depressed prices during the big sell-off in risk assets at the end of last year; Janus Henderson correctly calling yield moves in the US and Australia; and Baillie Gifford reducing exposure to high-yield bonds after many economic indicators changed from ‘green’ to ‘amber’ (see box).

Some funds are conservatively managed; others more adventurously so. Some managers allow the macroeconomic environment to dictate their investment decisions; others put greater emphasis on individual bond selection.

Volatility was a problem for some funds

Name 3m (%) Rank 1yr (%) Rank 3yrs (%) Rank 5yrs (%) Rank
Pimco GIS Income 3.3 20/89 11.2 1/84 33.3 1/77 67.4 1/70
Allianz Strategic Bond 1.3 82/89 8.5 2/84 12.6 39/77 21.3 24/70
Royal London Sterling Extra Yield Bond 2.6 47/89 5.0 3/84 32.4 2/77 39.9 4/70
Janus Henderson Fixed Int Monthly Inc 3.8 5/89 5.0 4/84 17.3 11/77 26.2 11/70
Pimco GIS Diversified Income 3.1 27/89 4.8 5/84 16.9 13/77 22.8 18/70
Royal London Global Bond Opps 2.7 38/89 4.7 6/84 21.8 5/77    
Quilter Investors Diversified Bond 4.1 2/89 4.5 7/84 13.9 27/77    
Janus Henderson Preference &Bond 3.4 18/89 4.5 8/84 15.5 20/77 23.9 15/70
Baillie Gifford Strategic Bond 3.8 6/89 4.4 9/84 21.3 6/77 29.2 7/70
Aviva Inv Managed High Income 2 3.6 11/89 4.2 10/84 13.7 28/77 21.5 22/70

Notes: Performance and rankings of IA strategic bond sector funds. * The unhedged USD share class of this fund is not readily available to retail investors. Source: Financial Express to 30 April 2019

A conservative pick

Allianz Strategic Bond, the second-top performer over one year, is the most conservative of those on Financial Express’ (FE’s) list of recommendations. It has 66 holdings and two-thirds of its assets in government bonds, with those issued by the Chinese, US, Czech Republic, Italian and South African governments the top five holdings. It uses a top-down investment process, with managers Mike Riddell and Kacper Brzezniak recently re-entering a short position (to profit on falling bond prices) in US high-yield bonds on the basis of the economic backdrop.

“US corporate leverage is the highest it’s ever been, we’re approaching the end of the 10-plus-year-long credit cycle, and with valuations once again very stretched, now is not the time to chase yield in corporate bonds,” says Riddell.

Standing in stark contrast is Royal London Asset Management, which has a strong preference for high yield. Head of credit Eric Holt and co-manager Rachid Semaoune take a bottom-up, stockpicking approach to portfolio construction. They prioritise income generation and have virtually no exposure to government bonds, where yields are low.

Royal London Sterling Extra Yield, one of Canaccord Genuity Wealth Management’s more adventurous picks, and Royal London Global Bond Opportunities, the third and sixth best performers over a year, have a spread of around 200 holdings each across investment grade, sub-investment grade and unrated corporate bonds. More than one-third of assets are in unrated bonds. In this way, the Royal London managers are able to generate a yield of around 6%, double that of the Allianz fund.

In theory, government bonds offer shelter in times of uncertainty and high-yield bonds are the best place to be when the economy is motoring, but FE research manager Charles Younes thinks the same could also be said with regard to the late stages of the economic cycle.

“Contrary to government bonds and investment grades, the sensitivity [of high-yield bonds] to interest rates is lower. High-yield bonds also benefit from equity-like characteristics – an equity rally is typical for this kind of late cycle,” he says, questioning whether this end cycle will diff er from a ‘classic’ one.

There is debate too over how ‘late’ we are in the cycle. Sabina Raza, a portfolio manager at Barclays Investment Solutions, points to the lack of increase in the issuance of lower-rated CCC bonds – something that usually happens when the asset class is late-cycle. “With the change in rhetoric by central banks, the credit cycle may still have further to go,” she says. Nevertheless, she notes that managers have been reducing risk, shortening duration and preferring more defensive, non-cyclical sectors such as food and beverages.

The barbell approach

Patrick Thomas, an investment manager at Canaccord Genuity, believes it is “hard to ignore the relative value in short-term bonds right now,” given a flattening in the yield curve (the difference in yield across contract lengths).Some managers have adopted a barbell approach, holding quality government and corporate bonds alongside riskier propositions. Among them is Janus Henderson. Switches in allocations over the past year have put two of its funds in the top 10. It went aggressively long duration in government bonds during the fourth quarter as central banks backtracked on monetary tightening amid a slowdown in the global economy, but has begun to scale this position back.

Whether John Pattullo, co-head of strategic fixed income, turns more defensive depends on the outlook for the US economy. “The jury is still out,” he says; but given his barbell approach, he says he is “well-positioned either way”.

“Textbook economics sees this as an odd combination because good government bond performance typically means a weaker economy, which is bad news for high-yield corporate bonds – but unconventional monetary policy means markets are behaving unusually, so it has been possible to barbell returns,” he says. “We think interest rates have peaked, but are not slaves to a particular duration position and will tactically manage the portfolio.”

Baillie Gifford: keeping some powder dry

With the US in late cycle and global debt above its pre-financial crisis levels, the Baillie Gifford Strategic Bond fund, ninth in the sector over one year, has turned more cautious. It has 32% in high-yield bonds compared to 40% at the start of 2017.

Torcail Stewart and Lesley Dunn are running with their best ideas – companies producing the products and services of the future, where balance sheet improvement from management turn around or structural growth is likely – while “keeping some powder dry” in shorter-dated defensive bonds. “We constantly have a range of individual bond investment cases that have the potential to deliver almost regardless of broader market trends,” says Stewart.

Recent strong performance has come from data centre operator Equinix, Bank of America and Netfix, the “media content producer of the future”. All three have experienced rating upgrades in the past six months.

The managers have also been adding to UK insurers, banks, high yield and hybrid bond issuers, which are benefiting from a ‘Brexit risk premium’ – lending to Pure Gym and Co-operative Group on a 5% yield, and National Grid and Yorkshire Building Society on a 4% yield. They are balancing this with very high quality or short-dated bonds. One-fifth of the fund is lent to businesses with a credit rating of A or better.

“Baillie Gifford Strategic Bond’s managers look at individual bonds and try to ignore the macroeconomic environment – this means it looks a lot different from many other funds,” says Darius McDermott at FundCalibre. “They are very good stockpickers, so tend to do well.”

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