With the global economy on the road to recovery after the financial crisis, the consensual view is that the outlook for fixed income funds looks poor.
A rising yield environment, potential interest rate hikes and high starting valuations are all expected to add to bond-holders’ misery over the coming two to three years.
However, there is still clearly demand for fixed income funds as they dampen down equity market volatility, provide a reliable source of income and help to deliver a more rounded total return within a portfolio.
With that in mind, we ask the experts what are the main characteristics every investor should look for in their bond fund if they want it to successfully navigate the currently uncertain environment.
A very high degree of flexibility
Rob Morgan (pictured), pensions and investment analyst at Charles Stanley Direct, says that the first and most important aspect is to look for a manager who can invest across the whole of the fixed income market.
“It’s really difficult because they are large parts of the global bond market that aren’t looking very attractive at the moment,” Morgan said. “Because of that, it really is important that bond managers have a lot of flexibility and can tactically go anywhere within the market. You don’t want them to have any constraints and I would look within the strategic bond sector.”
Funds within the IMA Sterling Strategic Bond sector have the ability to invest across global fixed interest markets, including sovereign debt, investment grade corporate credit, high yield credit, loans and asset backed securities.
They can also invest up to 20 per cent of their assets in equities and portfolios that have taken full advantage of that allocation have been Artemis High Income and Invesco Perpetual Monthly Income Plus.
One fund within the sector which is highly-rated by the FE Research team, and doesn’t dip into the equity market, is the five-crown rated Jupiter Strategic Bond fund.
The £2.1bn fund, which is headed-up by FE Alpha Manager Ariel Bezalel, has been the best performing fund in the sector since its launch in June 2008 with returns of 85.17 per cent, beating its benchmark – the iBoxx Sterling Non-Gilts All Maturities index – by 45 percentage points.
Performance of fund vs sector and index since June 2008
Source: FE Analytics
The fund yields 5.2 per cent and Bezalel holds a mix of high yield bonds, including corporate credit and sovereign debt from peripheral European economies such as Greece and Cyprus, as well as higher rated debt such as Australian government bonds. In total, he has more than 380 individual holdings.
Bezalel can now also use derivatives to add alpha and to help overall portfolio management.
Other five-crown rated funds in the sector include Standard Life Corporate Bond and Old Mutual Monthly Income Bond.
A nimble size
The question of how much of an impact a fund’s size has on its performance has been hotly debated.
Most agree, however, that a larger AUM is more likely to affect an equity fund than a bond fund. Morgan agrees, but while he says funds of all size would be hit by huge sell-off in the market, he says managers who running less money have a greater chance of outperforming on a stock-by-stock basis.
“Liquidity will affect all bond managers, but it is easier to add alpha via stock-picking if you are running a smaller fund,” Morgan explained.
“Managers running very, very large funds can only really outperform if they get their macro-calls right, regarding duration risk or preferring investment grade over high yield, for example. Smaller funds can target particular bond issues, which gives them an advantage.”
He added: “I’m not saying large funds can’t ever do that as well, but it is just a lot more difficult. Every bond manager seems to say that liquidity is becoming a problem, so the smallest funds have better chance of generating alpha by following their best ideas.”
The largest UK-based IMA Strategic Bond fund is FE Alpha Manager Richard Woolnough’s £21.3bn M&G Optimal Income fund.
Performance of fund vs sector since Dec 2006
Source: FE Analytics
Our data shows that it has topped the sector since its launch in December 2006 with returns of 86.93 per cent.
However, given its size and the increasingly illiquid nature of the current bond market, pockets of the fund management industry have deemed it unlikely that Woolnough will be able to replicate those sorts of returns in the future; despite his highly rated ability.
Woolnough himself has defended the size of the fund on many occasions, but admits that every day the fund gets larger; it becomes more difficult to run.
One of the smaller funds in the sector, which has the coveted five-crown rating, is George Luckraft’s £123m AXA Framlington Managed Income fund. It boasts top quartile returns over one, three and five year periods.
An experienced management team
Neil Shillito (pictured), director at SG Wealth Management, is concerned about the outlook for bonds and therefore thinks it is vital to choose a management team which is highly experienced.
“Bonds are very, very sensitive to economic conditions,” Shillito said. “However, what tends to happen throughout the cycle is that you get very misleading and often overly emotional headlines which can affect certain managers. Yes, if interest rates were to rise it would hurt bonds, but the global bond market is so huge, it isn’t going to be the complete end to fixed income.”
“That is insane and illogical.”
“We want experienced teams who have been there, done that and got the t-shirt because they are the ones we hope will keep their head during times of uncertainty and squeeze out a few basis points of outperformance through their knowledge of the market.”
Shillito has, because of that, recently been buying FE Alpha Manager Anthony Smouha's GAM Star Credit Opportunities fund.
Smouha, who has a track record spanning back to 1992, launched his £107m fund in June 2011. According to FE Analytics, it has been the best performing fund in the IMA Sterling Strategic Bond sector over that time with its returns of 43.59 per cent.
Performance of fund vs sector since July 2011
Source: FE Analytics
Smouha invests across the credit spectrum and currently has high exposure to fixed and floating rate notes. The manager also uses derivatives within the fund.
Shillito particularly likes the fund as Smouha is willing to dip into lower-rated debt, but from companies that are investment grade as those bonds offer decent income and are less risky than buying bonds from very low credit-quality business.
The fund currently yields 4.97 per cent.
