The manager of the £1.4bn Fidelity Strategic Bond fund says the best-performing areas of the market – namely high-yield and low duration – could be set for a harsher period of performance, and warns investors against chasing past returns.“It is a good time for bond investors to reassess the balance of risk in their portfolios,” said Spreadbury (pictured).
“Across capital markets an excess of savings confront a world of slow growth, low inflation and easy monetary policy. Bond yields are falling as liquidity drives valuations higher.”
“Investors' search for yield has focused on extending credit risk, while reducing interest rate risk. But this trend may have run its course; there is a danger of overreaching for returns at the wrong point in the credit cycle.”
“I expect portfolios will need a careful balance of duration and credit risk to achieve decent risk-adjusted returns going forward.”
The best performing bond funds of recent years have been those prepared to take on a higher level of risk.
IMA Sterling High Yield has been the best-performing bond sector over three and five year period, with the likes of Invesco Perpetual High Yield and Kames High Yield Bond leading the way.
The best-performing IMA Strategic Bond funds have also been those with a high-yield focus, such as Royal London Sterling Extra Yield Bond.
By contrast, those with more of a focus on investment grade bonds and lower volatility have struggled on a relative basis, such Spreadbury’s own Fidelity Strategic Bond portfolio.
Performance of sectors and funds over 5yrs
Source: FE Analytics
Spreadbury thinks the entire bond market is at risk of a steep sell-off in the coming months as monetary policy tightens and yields rise, meaning that the need to manage risk has become more important than in recent years.
“Systemic risk remains high across the global economy in this environment,” he said.
“There have already been flash points in the banking sector, peripheral eurozone economies and emerging markets, but it is impossible to pinpoint a trigger for the next crisis. Often it is something off the radar.”
“However, I fear the consequences could be nasty since most governments and central banks now have limited capacity to bail-out their economies again.”
With valuations edging ever higher and the macro picture still very challenging, Spreadbury suspects that investors’ willingness to invest in riskier areas will soon reverse.
This, he says, will favour bond funds that focus on quality and downside risk.
“A prolonged period of low rates will continue fuelling investors search for yield. Up to now many investors have focused on adding credit risk at the expense of duration, but I believe there is a limit to how far down the credit curve investors are willing to go as valuations grind higher,” he said.
He thinks that an environment akin to 2006/2007, when valuations in high-yield debt was at a similar high, could be occurring.
While Spreadbury doesn’t think it will result in a correction on the same level for high yield, he thinks investors should be very wary.
“Spreads to government bonds in these credit markets have compressed substantially and are now not far from their tightest ever levels, mostly set back in 2006/07 just before the financial crisis,” he said.
Performance of sectors and funds 2006-2010
Source: FE Analytics
“At that time investors began leveraging their investment to squeeze out additional returns. Like today, low duration, high credit risk strategies were also common place at that time.”
“It is difficult to see that trend returning to the same extent, but the savings glut and low interest rates could have an identical effect – pushing credit spreads beyond their tightest levels, while sowing seeds for a future crisis.”
“This makes the market environment difficult for investors. Risks become more asymmetric, but reducing long credit positions too early can severely curtail returns. Thankfully, I sense investors are becoming more cautious and are beginning to enhance yield through extending duration to balance credit risk.”
This is exactly what Spreadbury has been doing across his Fidelity Strategic Bond fund.
He remains overweight corporate bonds but mostly in high quality investment grade, and has moderate interest rate risk.
“Running a moderate duration provides downside protection if we get another nasty macro shock or the economic recovery runs out of steam. I am also mindful that my funds sit within an investor’s wider portfolio, so keeping some duration is important for providing diversification to equities and other risky assets,” he said.
“Duration is just over six years in the Fidelity Strategic Bond fund and is diversified across currencies to profit from the growing variation in economic cycles across the world.”
“Asset allocation is skewed towards credit, with half the fund in investment grade corporate bonds and a third in high yield. I am at the high end of the range for high yield and exposure is unlikely to increase much from here.”
The manager’s sector allocations are still generally defensive, with a bias towards consumer staples, transport and utilities.
He maintains a moderate exposure to financials, bar-belled between high-quality covered bonds and subordinated bonds.
While Spreadbury is cautious on the whole, he has increased his exposure to one of the riskier areas of the bond market on valuation ground.
“I [recently] increased exposure to emerging market debt, although it still only represents around 7 per cent of the fund. There is potential for more volatility, but investors were indiscriminate during the recent sell-off, leading yields in some areas to offer decent compensation for the extra risk.”
“I added small amounts to Turkish government bonds and Mexican inflation-linked government bonds. However, I cut exposure to Russian issuers and bought protection through the credit default swap market on Russia and Ukraine sovereigns.”
Performance of fund and sector since launch
Source: FE Analytics
Though Fidelity Strategic Bond has had some bouts of underperformance since its launch in April 2005, overall it has beaten its peer group with more volatility.
The fund has returned 73.87 per cent since inception – more than 20 percentage points more than its IMA Sterling Strategic Bond sector average.
