Recent weeks have seen the bond market return to the spotlight after concerns about the potential for higher inflation and the timing of the Federal Reserve’s first interest rate increase sparked a sell-off in fixed income assets.
The jury is still out on whether the volatility is a temporary setback or the start of a more prolonged rout from the fixed-income space. Although bonds have had a strong run over recent years, a number of investors include Janus’ Bill Gross and JP Morgan’s Bill Eigen have warned that their 30-year bull run is about to come to a crashing end.
The sell-off means that bond funds have been the worst performing portfolios over 2015 so far. As the graph below shows, IA Global Bond is the peer group with the worst year to date returns after the average fund lost 0.58 per cent while IA Gilts is down 0.44 per cent.
Meanwhile, the average IA Global Emerging Market Bond fund has made 1.46 per cent, IA Sterling Corporate Bond 1.10 per cent and IA UK Index Linked Gilts 1.34 per cent.
IA Sterling Strategic Bond, however, has beaten IA Targeted Absolute Return with a 1.95 per cent average return. Leading the pack is the IA Sterling High Yield sector, where the average fund is up 3.50 per cent.
Performance of bond sectors over 2015
Source: FE Analytics
Given the turbulence that has been seen in the market – and as it is expected to continue in the future – many experts are tipping strategic bond funds as the vehicles to navigate these conditions, thanks to their flexible mandates.
With that in mind, FE Trustnet has quizzed the strategic bond funds outperforming their rivals over recent months to find out what has been driving those returns and how they are currently positioned.
FE Alpha Manager Anthony Smouha’s £184.6m GAM Star Credit Opportunities is topping its sector year to date with a 5.32 per cent return. This follows first-decile numbers in 2014, 2013 and 2012.
“One of our preferred holdings is the Man Group 5.875% bond. It will have provided 11.75 per cent income over two years, so if rates go up it would still deliver an extremely attractive return over cash. We take a long-term buy-and-hold view when selecting investments – an approach we like to refer to as a ‘wide-angled time lens’,” the manager said.
“It is always prudent to remember that there are two components to a bond: the coupon and the price. The markets frequently focus on headline-grabbing price movements, paying less attention to the small daily increments offered by the coupon – 0.01632 per cent per day in the case of the Man Group 5.875% bond.”
Other positions which have helped GAM Star Credit Opportunities since the start of the year include the use of “idiosyncratic securities” such as fixed-to-floater bonds, which offer a steady yield for several years then move over to a floating rate that keeps up with market interest rates. This allows the fund to benefit from rising rates, as well as offering a source of diversification.
Looking at positioning, Smouha said: “The market is continually warning of a bond sell-off to come; our view is that we are unlikely to see a repeat of the five-step rise in rates that we lived through in 1994. More likely is a move of one step this year followed by a pause, but any initial move is dependent on both evidence of a sustained pick-up in GDP and that the output gap is closing.”
“The GAM Star Credit Opportunities strategy is not driven by interest rates; instead we concentrate on earning coupons over time. This somewhat shields us from bond market headline moves, such as the recent bund sell-off, and acts as a reminder that there are different ways of investing in the bond markets – locking in attractive coupon income can provide a good buffer against interest rate moves.”
Performance of funds vs sector over 2015
Source: FE Analytics
Mark Harris’ £8.9m City Financial Diversified Fixed Interest fund has made 5.03 per cent over the year to date and the manager puts this down to a portfolio that is positioned differently to the bulk of bond funds in the market.
“The fund has enjoyed a very strong start to 2015, in terms of both total return and income earned. We have consistently highlighted the non-consensual nature of our strategic outlook relative to many peers, helping lead to a differentiated performance profile,” Anthony McDonald, senior investment analyst at City Financial, explained.
“At the start of the year, our concerns that consensus expectations for US economic growth were too high led us to hold significant exposure to long-dated bonds in January and March.”
“This long duration positioning was extremely beneficial and the main driver of the fund’s outperformance to date in 2015. It was managed more tactically than last year, as our risk models highlighted the likelihood of higher volatility in bonds this year.”
McDonald also highlights a bias towards high-yield, which helps the fund to achieve its income aims, as a driver of performance. As mentioned earlier, high-yield bonds have rallied in the early months of 2015 while government debt – on which Harris has become “less positive” – has struggled.
City Financial Diversified Fixed Interest is a fund of funds and its top holdings include Legg Mason Income Optimiser, Schroder Monthly High Income, Kames Capital High Yield Bond and PFS TwentyFour Dynamic Bond.
Artemis High Income has made 4.46 per cent over 2015 so far and Alex Ralph, who is co-manager on the fund with the FE Alpha Manager duo of Adrian Frost and Adrian Gosden, puts this down to several factors.
“There have been a number of positive events, including buybacks and M&A activity as economies recover. In addition, our overweight position in financials is continuing to create excess return as the sector goes on increasing its safety cushion (capital) and implements reorganisation of balance sheets,” Ralph said.
Financials are the portfolio’s largest sector weighting, accounting for 49.8 per cent of assets. Within the top 10 are bonds issued by the likes of Standard Life, Legal & General Group, RSA Insurance and PGH Capital.
While the fund’s total return has been strong, it is important to note that the managers’ focus is on income generation not capital gains.
The FE Research team said: “The managers should remain focused on returning an attractive income without taking into consideration capital appreciation.”
“Considering the current yields on government bonds, they are likely to retain their preference for corporate debt, especially at the crossover between investment grade and high yield sectors.”
Performance of funds vs sector over 3rs
Source: FE Analytics
PFS TwentyFour Dynamic Bond, which is managed by Eoin Walsh, Gary Kirk, Felipe Villarroel and Pierre Beniguel, is up 4.45 per cent in 2015. The fund has a flexible approach to the fixed-income market and often has holdings that retail investors usually have little or no exposure, such as asset-backed securities and bank debt.
The fund is a concentrated portfolio of between 65 and 85 positions and the managers say stock selection is an increasingly important element of its outperformance
Banks is one area that the managers like and have had success in this year. Some 25.79 per cent of the portfolio is in bank debt, including bonds issued by Coventry Building Society, Nationwide, Barclays, Lloyds and Spain’s BBVA.
Meanwhile, the fund has exposure to peripheral eurozone sovereigns, but only on a duration-hedged basis, and European asset-backed securities (ABS), which are beneficiaries of the European Central Bank’s ABS purchase programme.
It also has 23.64 per cent of assets in high-yield bonds, which have performed strongly so far this year.
The FE Research team said: “This fund takes a very distinctive approach. The fund complements traditional fixed income funds well and can also be used as an alternative for anyone worried about a potential correction in the bond market when interest rates rise.”
Eve Tournier, manager of the Pimco GIS Diversified Income fund, attributes her strong showing in 2015 to allocating across global credit markets in a “diversified and tactical manner”. The fund has posted a 4.12 per cent total return since the start of the year.
“Strategies designed to benefit from accommodative monetary easing by the European Central Bank have contributed strongly to the fund’s performance. This includes PIMCO’s bias to European bank capital securities and peripheral credit issuers,” she said.
“Within high yield, security selection within the media and energy sectors has been an important driver of returns. Within emerging market, our exposure to quasi-sovereign and select corporate credits in Russia and Brazil have contributed to performance as spreads in these markets have tightened. The portfolio has also benefitted from a long dollar versus euro currency positon.”
High-yield is the fund’s largest sector allocation at 34 per cent of assets, followed by emerging market debt at 31 per cent. It also has 27 per cent in investment grade, 8 per cent in mortgage-backed securities and 7 per cent in government debt.
For those investors concerned by the future direction of the bond market, FE Trustnet is going to be taking a closer look at bond funds that take an absolute return approach to investing.
