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Are you buying top-performing bond funds for the wrong reasons?

27 February 2014

Bond funds that have been prepared to take on more risk have prospered from a relative point of view recently, but they could be set for tough times ahead in a risk-off environment.

By Joshua Ausden,

Editor, FE Trustnet

The best-performing bond funds over a five-year period have been those with the highest correlation to equities, according to FE Trustnet research.

Funds that have been prepared to take on more risk and invest in high yield or junk bonds – which behave more like equities than investment grade corporate and sovereign debt – have been rewarded over the period.

Those with a flexible enough mandate to invest in equities have done even better.

Our data shows that the average IMA Sterling High Yield fund has more than doubled investors’ money since February 2009, only slightly underperforming the FTSE All Share over the period.

Funds with a higher quality focus in the IMA Sterling Corporate Bond, IMA Sterling Strategic Bond and IMA UK Gilts sectors have fallen well short.

Performance of sectors vs index over 5yrs

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Source: FE Analytics

High yield funds are also ahead over one and three years.

Within the popular IMA Sterling Strategic Bond sector, managers that are overweight high yield debt are among the top performers.

Eric Holt’s £883m Royal London Sterling Extra Yield Bond fund tops the sector over three and five years with returns of 38.88 and 143.22 per cent, respectively – figures that are ahead of the FTSE All Share's gains.

Holt has 60 per cent in high yield debt, which is classed as anything with a credit rating of lower than BBB, and 3 per cent in equities.

It has a 0.55 correlation to the FTSE All Share over the five years, which is well above average for a fund in the sector.


Performance of fund, sector and index over 5yrs

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Source: FE Analytics

All of the other funds that have at least doubled investors’ money over the period, including Paul Causer and Paul Read’s Invesco Perpetual Monthly Income Plus fund, have a high degree of exposure to high yield.

The Invesco fund has benefited from the manager’s overweight in high yielding European debt, as well as its consistent 15 to 20 per cent position in equities.

The fund has an even higher correlation to the All Share than Royal London, at 0.75 over a five-year period.

Unsurprisingly, many of the funds that have performed well over three and five years have proved popular with investors in the sales stakes.

M&G Optimal Income
– another top-performing fund that has benefited from its equity exposure – has been the best seller, with inflows of more than £3.5bn over a one-year period.

Artemis High Income, which has 17.1 per cent in equities at present, has returned 110.16 per cent over five years and has seen inflows of £146m since February 2013, according to FE data.

Royal London Sterling Extra Yield Bond has seen assets grow by almost £200m in the last 12 months.

While investors in these funds will be pleased with performance, experts argue that anyone buying into them now needs to make sure they’re doing it for the right reasons, and not only because they have performed well.

AFI panellist and fund of funds manager at Charles Stanley Shauna Bevan says that holding a high yield fund or a strategic bond fund skewed towards high yield has merits in its own right, but that anyone looking for a traditional low-risk bond fund with a healthy yield could be left disappointed.

“There has been a general hunt for yield because of zero interest rates, and investors have been going up the risk curve. It’s not surprising that high yield is popular,” she said.

“We are coming to the end of a bull market in bonds and given where duration risk is, I wouldn’t say that buying into high yield is the worst idea. Spreads in high yield are tight but they could go tighter.”

“That said, if you are looking for a volatility dampener then piling into high yield isn’t very sensible. I think you need to be cognisant of the risks. If the manager of your bond fund has increased their high yield exposure and you already have an equity-heavy portfolio, you need to be aware.”

While high yield has had a great run over the past five years, Bevan points out it is more susceptible to sharp falls than investment grade quality debt.

“In the event of a market sell-off when equities fall 20 per cent, high yield should hold up better, but there is a lot of correlation there,” she said.

In 2008, for example, the average IMA High Yield bond fund fell 25.37 per cent – only slightly less than the FTSE All Share.


The Royal London Sterling Extra Yield Bond fund fell more than 33 per cent, which is no longer reflected in its five-year numbers.

Performance of fund vs sectors and index over 7yrs
 
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Source: FE Analytics

Though a favourite with Hargreaves Lansdown’s Mark Dampier, Bevan says she has never considered buying the Royal London fund.

Mike Deverell, another AFI panellist and investment manager at Equilibrium Asset Management, agrees that investors need to be very careful when considering what bond fund to buy.

“It’s true with any fund that you have to know exactly what you’re buying, but especially a strategic bond fund given how diverse the sector is,” said Deverell.

“Conceivably, one could be 100 per cent in high yield while another could be invested in gilts and investment grade credit.”

“It all comes down to what you’re looking for. If you want a steady income and defensive focus which someone like Ian Spreadbury gives you, then there are periods when it could underperform, but when the market goes the other way it will do much better.”

FE Alpha Manager Spreadbury’s £1.4bn Fidelity Strategic Bond fund is currently a third quartile performer in its IMA Strategic Bond sector over one and five years, and second quartile over three.

However, he says he has no intention of increasing the risk exposure in his fund, because it is performing in exactly the way he wants it to.

“I position my fund as a traditional bond fund, that is what the majority of bond investors look for – namely regular income with a relatively low volatility and relatively low correlation to equities,” he said.

“We have 30 per cent of high yield in the fund and 20 per cent in financials. There is a lot of overlap there now – around half of the financials exposure is high yield.”

“We capped the high yield exposure at 50 per cent when the fund was launched, because research showed us that when high yield gets higher than this in a strategic bond fund, two things happen that we don’t want.”

“One, the volatility gets too high, and secondly the correlation gets too high compared with equities.”

“We’re not saying that it’s wrong to be in high yield, we’re just saying that in order to achieve our objective we have a cap.”

Spreadbury points out his fund has delivered annualised returns of 7.8 per cent gross of tax and fees since its launch in 2006, compared with 9.8 per cent from the European high yield index.

“We’ve slightly underperformed, but European high yield is at the top of its performance cycle, with spreads very high. Over the period we’ve had an annualised volatility of 5.5 per cent compared with 13.1 per cent,” he continued.

“We’ve specifically structured the fund to produce what we think is the best balance between risk and return. If there was a downturn we would underperform bonds, but given that we’re focused on high quality we are sure we would do well in a downturn.”

Deverell prefers Jupiter Strategic Bond and Invesco Perpetual Tactical Bond to Fidelity Strategic Bond, because they have more flexibility when it comes to managing duration.

Although Spreadbury has historically protected better against the downside than his peers, Deverell thinks quality investment grade bonds will be susceptible to a steep sell-off once interest rates rise.

Bevan agrees that there are significant risks to investment grade, which goes some way in explaining why she holds absolute return funds to dampen volatility rather than bonds.

“My concern about investment grade corporate debt is liquidity,” she said.

“It’s been a one-way bet with everyone buying up the risk curve, but when that changes there could be a problem.”

“It’s not our base case, but if inflation suddenly spikes and these investment grade focused funds are more vulnerable to duration, I don’t think M&G and Fidelity will be able to exit at the same time.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.