Fund flow data suggests most investors are happy to choose the large multi-billion funds in the IMA Strategic Bond sector. FE inflows data shows that Richard Woolnough's £12bn M&G Optimal Income fund has taken more money in the last year than the rest of the sector put together, for example.
However, Magrath (pictured) says that at their sort of size liquidity concerns mean that the funds can make few gains through stock selection, and are limited to making calls on which part of the market to be in.
“In our view a lot of strategic bond funds are too big to be strategic and too big given the liquidity of the market to be able to run the strategy they really want,” he said. “So for us we think the maximum size you can run a truly dynamic or strategic bond fund and be able to add value from bottom-up stock selection is between £500m - £750m.”
Magrath, head of distribution at Twenty-Four Asset Management, explains that liquidity in the bond market has fallen in recent years.
Before the crash banks were happy to hold large positions in a wider number of bonds and make a market in them, whereas these days they are content to act as brokers without taking the risk onto their own books.
This means the maximum size that can be traded has become significantly smaller – as low as £2m-£3m on some European high yield bonds.
“This is the maximum size you can hold and be sure you can get out,” he said. “And liquidity is often worse when you need it most.”
Magrath says that in order to take positions they can liquidate in a reasonable amount of time, large bond funds blend away any stock selection gains they could make.
“Most good bond managers know that so you will actually see big multi-billion bond funds will be running 500-700 different line items to get liquidity on their books.”
“You get the ability for them to play their top down view on broad parts of the market, but then you are saying “I am the market”.”
“This means you are not adding value from the bottom-up direction, but there’s a lot of work you can do from the bottom up.”
Twenty-Four launched the Twenty-Four Dynamic Bond fund in April 2010, and data from FE Analytics shows it is currently yielding 6.86 per cent, the second-highest in the IMA Sterling Strategic Bond sector.
The £112.3m fund has made 29.8 per cent in total return terms since launch, putting it in the top quartile of the sector.
Performance of fund versus sector and benchmark since April 2010
Source: FE Analytics
Magrath says that the team holds 50 – 70 positions, and because of its small size can get meaningful contributions to performance from issuances that larger funds would have to overlook.
For this reason it is able to generate its high yield while maintaining 44 per cent in investment grade credit.
For comparison, the average yield on an IMA Sterling High Yield fund is 5.97 per cent, according to data from FE Analytics.
In the IMA Sterling Strategic Bond sector the situation is much worse for yield-hunters, with the average yield as low as 4.22 per cent.
Magrath says that some issuances are too small for multi-billion funds to be able to take positions in, and the Twenty-Four Dynamic Bond fund can boost its yield by holding such investments.
“When you look across most bond funds, our typical position is much smaller. We would be uncomfortable holding £10m or more in one bond, perhaps even £5m-£7m.”
“We want to be able to be out of our position in two or three days.”
Magrath says stock-picking is becoming even more crucial to performance, making the advantages of a smaller fund even more useful.
“There is much higher divergence in the bond market now – much higher dispersion than there was pre-credit crunch. Therefore stock selection is increasingly important to be able to deliver yield,” he said.
“The right way to run a strategic bond fund is with 50-70 line items to be able to select the credit you think is right and not be forced to fish in parts of the market you do not want to be in.”
“With 50 names you can really select the bonds you like. You have a high degree of certainty in the returns from bonds, so your 50th best idea is far better than your 200th.”
“A lot of funds hold parts of the market they don’t like for liquidity reasons, and even equities.”
In an article later this week FE Trustnet will be looking at the Twenty-Four Dynamic Bond fund in greater detail.
