The stellar performance of equity markets since the summer of 2012 has led many fund managers to build up their cash content, in anticipation of a significant correction.
Historically low-yields in investment grade debt have pushed many funds in the Sterling Strategic Bond sector into riskier assets, reflected by the high yields on a number of vehicles. FE data shows that 15 strategic bond funds are yielding over 5 per cent, including the likes of Jupiter Strategic Bond, Henderson Strategic Bond and Artemis High Income.
Spreadbury (pictured) says the high level of correlation between equities and high yield debt would see riskier strategic bond funds suffer big losses if equities do indeed correct. He says he’s much more comfortable sacrificing yield in his Fidelity Strategic Bond fund, to ensure that it gives investors the diversification they need if markets take a tumble.
“It is nigh on impossible to achieve a yield above 5 per cent by investing purely in investment grade corporate bonds – bonds issued by blue chip companies such as Tesco, United Utilities and Rolls-Royce that carry an extremely low chance of default,” he explained.
“For instance, the yield on triple-B rated bonds across the US dollar, sterling and euro markets currently ranges from 2.2 to 4.2 per cent on average. So funds that yield above 5 per cent will probably be allocating a reasonable amount to higher yielding non-investment grade debt, where historical default rates have been much higher.”
“A factor sometimes overlooked by investors is that funds carrying greater credit risk are typically highly correlated to equity markets, whereas bonds are often bought for their diversification benefits to riskier assets.”
“Fidelity’s Strategic Bond fund is not one of the highest yielding strategic bond funds in the sector because I am looking for the best balance of risk and reward for investors seeking a core bond fund. The fund aims to deliver a consistent level of income, low volatility of returns and some diversification to equities.”
Spreadbury’s £1.4bn Fidelity Strategic Bond fund is currently yielding 3.35 per cent – much lower than the highest yielder in the sector, Royal London Sterling Extra Yield Bond, which is yielding 6.82 per cent.
As well as having a moderate yield, the Fidelity fund has underperformed its IMA Strategic Bond sector average over a one and five year period, and is only second quartile over three years. Royal London, on the other hand, is number one in the sector over a three and five year period, and top quartile over one.
Performance of funds and sector over 5yrs
Source: FE Analytics
However, looking at the results over six years – which includes the worst of the financial crisis – Fidelity Strategic Bond is ahead of Royal London Sterling Extra Yield Bond, with returns of 62.92 per cent. The latter lost more than the FTSE All Share in 2008 [33.38 per cent], while Spreadbury only lost 0.29 per cent.
Performance of funds and sector over 6yrs
Source: FE Analytics
Though a handful of funds in the IMA Sterling Strategic Bond sector have a consistently positive correlation to the FTSE All Share– defined by FE Analytics as a score greater than 0.75 – Royal London Sterling Extra Yield has only a moderate correlation.
Head of FE Research Rob Gleeson (pictured) says that more important than correlation is how funds behave in extreme circumstances, however. “When we put together our portfolios we look at event risk – in other words, whether funds react in similar ways in certain situations,” he said.
“A fund may have a low correlation to an index because its daily movements differ so greatly; however, when investors really need – for example in an extreme sell-off – then the correlation can spike.”
Eric Holt’s Royal London fund has a high yield bias, targeting one that is 1.25 times greater than the FTSE Actuaries British Government 15 Year index.
However, there are a number of more traditional strategic bond funds with a particularly high yield at the moment. Ariel Bezalel’s £1.9bn Jupiter Strategic Bond fund is currently yielding 5.3 per cent, while John Pattullo’s £1.1bn Henderson Strategic Bond fund is yielding 5.8 per cent.
Spreadbury says there is nothing wrong with investing in a strategic bond fund that has a high weighting to high yield, as long as investors understand that it lacks the diversification benefits of one with more of an eye on downside protection.
“The great strength of a strategic bond fund is its flexibility to invest across all parts of the bond market seeking out the best value,” he said.
“It is really important to understand what a fund is trying to achieve before judging whether the manager is taking too much risk or not. And there is a lot of variation across the sector.”
“Funds aiming for a yield higher than investment grade bonds must accept a higher degree of risk in terms of volatility, greater downside risk and a higher probability of default – albeit likely lower today than historical averages,” Spreadbury added.