It has been a particularly unpleasant time to be invested in fixed income over the past few months or so.
Though economic growth in the UK and US has been disappointing and the ECB and Bank of Japan have been pumping liquidity in the market, yields on the likes of UK gilts, US treasuries, German bunds and Japanese government bonds have all spiked.
Various explanations have been given for this phenomenon such as backlash against negative rates, improving European economic data and a lack of liquidity but, whatever the reason, some of ‘safest’ assets available to investors have seen uncharacteristically large drawdowns so far in 2015.
Performance of indices in 2015
Source: FE Analytics
Though the market has calmed over the last week, the large majority of industry experts think volatility will be a persistent factor for investors over the short to medium term due to the possibility of higher inflation and interest rate rises.
Tom Stevenson, investment director at Fidelity Personal Investing, says that while certain investors cannot just give up on bonds, they need to focus on managers who have a high degree of flexibility within their portfolios to navigate through what is likely to be a very turbulent market.
As a result, he says investors should concentrate on the IA Sterling Strategic Bond sector.
“Strategic bond funds put the important asset allocation decisions, as well as the actual security selection, in the hands of an expert, in many cases with years of experience through a wide variety of economic conditions,” he said.
In this article, Stevenson highlights his five favourite strategic bond funds for this uncertain market.
First up is the £1.3bn Henderson Strategic Bond fund, which is headed up by the FE Alpha Manager duo of John Pattullo and Jenna Barnard.
“The fund has an unconstrained approach to investing across fixed income asset classes, based on the team's assessment of the economic cycle,” Stevenson said.
“It’s a fluid process, combining bottom-up security selection with top-down macro factors. ‘We tend not to put ourselves in a box with regards to process,’ Pattullo and Barnard claim. ‘We are managing for an outcome and we will use the approach most suited to delivering this outcome. The outcome in this fund is a total return for investors.’”
According to FE Analytics, the four crown-rated Henderson Strategic Bond fund has been a top quartile performer in the sector over 10 years with returns of 74.04 per cent. It is also outperforming over one, three and five-year periods and has had a lower maximum drawdown than its peers over the longer term.
Performance of fund versus sector over 10yrs
Source: FE Analytics
The fund, which yields 4.8 per cent, has around 45 per cent in lower-rated credit and 35 per cent in investment grade corporate bonds. The rest of the portfolio is split between sovereign debt, asset backed-securities, loans and preference shares as well as 10 per cent cash weighting.
It has an ongoing charges figure (OCF) of 0.7 per cent.
At £23.6bn, M&G Optimal Income is by far the largest fund in the sector. While concerns about the size persist, Stevenson says investors are in safe hands with FE Alpha Manager ‘hall of famer’ Richard Woolnough.
“With the most unconstrained strategy across all funds in M&G’s bond range, Optimal Income is extremely malleable and can be altered if Woolnough feels it will benefit investors: ‘We try to look through the whole economic cycle and behave like a bond fund that’s taking lots of credit risk when that’s an attractive thing to do, when we think interest rates and inflation are coming down.’”
Woolnough launched the fund, which currently only yields 2.16 per cent, in December 2006 over which time it has been the best performing portfolio in the sector with returns of 89.89 per cent – meaning it has doubled the gains of its average peer in the process.
It has also beaten the sector in seven out of the last nine calendar years and has been top quartile for its risk-adjusted returns, downside risk, maximum drawdown and annualised volatility since its launch.
M&G Optimal Income currently has 59.4 per cent net exposure to investment grade credit, 29.3 per cent in high yield, 22.7 per cent in government bonds and 0.6 per cent in equities, although that weighting to the stock market has been as high as 10 per cent in the past.
The fund has an OCF of 0.91 per cent.
Stevenson also likes the £1.7bn Fidelity Strategic Bond fund, which is headed-up by the only other FE Alpha Manager ‘hall of famer’ in the bond world: Ian Spreadbury.
“It is a flexible fund, which allows Spreadbury to profit from whichever bond markets offer the best value through the course of the economic cycle.”
“He aims to deliver a consistent income by managing the fund’s credit risk (the chance of a company failing to meet its obligations to lenders) and duration (the sensitivity of bond prices to a change in interest rates).”
Spreadbury launched Fidelity Strategic Bond in April 2005 over which time it has comfortably outperformed the sector average with its return of 82.56 per cent. As the graph below shows, it has given its investors a much smoother ride than most – particularly during the financial crisis as it fell just 0.29 per cent in 2008 when its average peer posted double-digit losses.
Performance of fund versus sector since April 2005
Source: FE Analytics
Spreadbury’s focus on capital preservation is clearly shown as the fund has been top decile for its risk-adjusted returns and maximum drawdown over 10 years.
The fund, which has a relatively low yield of 2.84 per cent, is currently biased towards BBB and BB-rated bonds. Fidelity Strategic Bond has an OCF of 0.67 per cent.
FE Alpha Manager Ariel Bezalel, despite his relatively short career, has gained a very strong reputation within the industry and Stevenson thinks his £2.6bn Jupiter Strategic Bond fund is one of the best available to investors.
“Investment ideas for the fund come from the blending of Bezalel’s top-down views and his credit analysts’ bottom-up research. His focus is on deleveraging, improving credits, for which the downside risk is thoroughly assessed and monitored.”
“With an eye to enhancing the returns for the fund, Bezalel will also try identifying special themes and stories, such as company restructurings, which are not usually being covered and researched by most analysts.”
According to FE Analytics, Jupiter Strategic Bond has been the sector’s third best performing portfolio since its launch in June 2008 with returns of 88.6 per cent and has beaten its benchmark – the iBoxx UK Sterling Non-Gilts All Maturities index – by more than 20 percentage points in the process.
Performance of fund versus sector and index since June 2008
Source: FE Analytics
Bezalel took the decision last year to make the fund more defensive, which has lowered its yield but at 4.2 per cent it is higher than most of its peers.
The fund still has a high 63.6 per cent weighting to high yield corporate bonds and that positioning is balanced out by a 30 per cent weighting to sovereign debt – most notable bonds issued by the Australian government as they are his six largest individual holdings.
The fund has an OCF of 0.73 per cent.
The final fund on the list actually sits in the IA Targeted Absolute Return sector rather than the strategic bond sector, but Stevenson says it is a good-choice nonetheless as it has a very flexible mandate and prioritises downside protection.
“One way of reducing risk when investing in bonds is to take a global view, especially as the asset class matures around the world, particularly in emerging markets,” Stevenson said.
“The Newton Global Dynamic Bond fund has a strong five-year record. Managed by Paul Brain, the investment leader of Newton’s fixed income team, the fund exhibits a global thematic approach to investing.”
“The fixed income team conducts its own research to translate relevant themes into investments to capture the returns. The fund looks to beat a short-term cash index and does so by investing in government (developed and emerging markets) and corporate debt (investment grade and high yield) around the world.”
Brain has managed the £1.2bn Newton Global Dynamic Bond fund since its launch in April 2006. The fund has returned 58.85 per cent over that time with a maximum drawdown of just 10 per cent. It has also had 72 positive months out of a possible 106.
The fund invests across various areas of the fixed income market such as corporate bonds, high yield, government bonds, emerging market bonds, convertibles and index linked-bonds. It also invests across different regions and the manager takes currency positions as well.
Newton Global Dynamic Bond has an OCF of 0.81 per cent.