Former L&G manager Dickie Hodges has launched his new Nomura Global Dynamic Bond fund to defend investors against the now highly illiquid, expensive and “broken” fixed income market.
Hodges became one of the leading lights in the strategic bond fund space during his time on the L&G Dynamic Bond fund, holding the coveted FE Alpha Manager rating until he left the group in May last year.
Over his tenure on the fund (which he launched in April 2007 and which peaked at an AUM of £2.3bn), it was a top decile performer in the IA Sterling Strategic Bond sector with returns of 87.62 per cent, more than doubling its average peer’s return in the process.
Performance of fund versus sector under Hodges
Source: FE Analytics
One of the odd features about the fund, though, was that Hodges was positioned for a bear market in his asset class due to the very low yields on offer, diminishing levels of liquidity and the possibility of tighter monetary policy.
He told FE Trustnet on a number of occasions about the importance of running a low duration portfolio and buying protection against rising yields and says his new Nomura Global Dynamic Bond fund (which launched earlier this year) is run along the exact same lines.
His new fund, which weighs in at £75m, has 21.68 per cent invested in securities which will mature in the next three years (which he hopes will allow him to redeploy his cash into higher yields) and is substantially hedged against a spike in government bond yields and wider credit spreads.
Speaking to exclusively to FE Trustnet, he says this defensive positioning is imperative in the current environment.
“The hedging is the main thing about this fund. We have told investors that it will remain hedged. It is as a cost to income but we will use them to mitigate downside risks in the asset class,” Hodges (pictured) said.
“Protection is a very fickle word as it would imply that you are never going to have negative returns, but during the days of big negative returns from bonds this fund should be less negative but as a consequence of that when everything rallies this fund will produce a positive return, just not as much.”
Investors will know that many experts have predicted a bear market bonds for some time now.
While those fears finally seemed founded earlier this year as yields on developed market government bonds spiked significantly due to a lack of underlying liquidity, yields have once again fallen as a result of the China-induced equity market sell-off.
Performance of indices in 2015
Source: FE Analytics
Despite that positioning, Hodges is quite relaxed about the overall performance of the bond market over the coming year or so.
He doesn’t, for example, foresee the much talked about ‘Armageddon’ event in fixed income happening anytime soon, given western economies don’t appear strong enough for higher interest rates and as global inflation could turn negative on the back of China’s slowdown.
Nevertheless, as he told FE Trustnet last week, there have been some worrying developments within market thanks to years of central bank intervention and an increasing herd mentality among investors.
“This market is broken and it’s a joke,” he said.
For instance, while he says he can only see bubble in fixed income bursting when interest rates rise, he warns that the current bond market is priced for perfection while liquidity has worsened considerably over recent weeks.
“I use options all the time – options on interest rates and options on credit markets. I have to do it on much larger size than I have done in the past. You’ve got to hedge because you cannot sell bonds,” Hodges said.
Again, while he doesn’t expect yields to rise significantly over the next 12 months, given those developments, he is happy to hold a defensive portfolio in the meantime.
“Because it is a total return fund, we want to distribute a level of income that meets people’s expectations but also gives them a measure of capital. At all times, we are trying to have the mentality of absolute return.”
“We are buying puts so that when interest rates go higher, government bond yields go higher and credit spreads go wider then we will generate a positive return. Obviously, puts cost money and when volatility goes up the cost of puts gets more expensive.”
“We have to spend some of our income and accept that we are not going to generate 100 per cent returns from the asset class because it is initially going to be a cost to income as we always want to have this protection in place.”
He added: “Just because it costs money today, we know we can recuperate those losses at a later date.”
Hodges launched the Nomura Global Dynamic Bond fund in January this year, but it hasn’t got off to the strongest of starts.
According to FE Analytics, it is down 3.31 per cent in sterling terms (although it is usually priced in dollars). While it sits in the offshore universe, those losses means it is down against Hodges’ old IA Sterling Strategic Bond sector average.
Performance of fund versus sector since launch
Source: FE Analytics
There have been a number of reasons for that underperformance, though. Firstly, the strength of sterling has had an impact and secondly the manager admits that he felt hedging his portfolio had become too expensive during June’s volatility and had allowed some of his puts to ‘roll off’.
He says he wasn’t therefore as protected as he would have liked and says it was a “big mistake”.
Nevertheless, he has once again hedged his portfolio and even raised his cash to 25 per cent given macroeconomic concerns surrounding China, pointing out that there will be a better time to put money to work in the future.
Of course, many potential investors may feel Hodges’ Nomura fund is too defensively positioned given interest rates are unlikely to rise this year thanks to the recent negative sentiment and as inflation is still running at very low levels.
However, the manager says investors’ mentalities need to change as they cannot expect the capital gains which bond funds have delivered over the past quarter of a century to happen again given the very low yields on offer.
Performance of sectors over 25yrs
Source: FE Analytics
“Yes, you’ve got to accept that we are in a different environment for fixed income (and equities) in which we have got to try and generate returns and manage money. You’ve got to be flexible.”
He added: “Obviously, it helps having a fund that is flexible enough and unconstrained in its nature. Everyone looks at the word unconstrained and thinks more risk, but I think it looks less risky.”
It is clear that investors in bonds are facing a difficult decision.
While they are often told to concentrate on managers who are experienced and have a very flexible strategy to cope with what is likely to be a tough few years for fixed income, most of the best known names are now running giant funds which could impact their ability to be flexible.
“With interest rate rises on the horizon, we are uncertain how interest rate sensitive areas of the bond market will react.” Whitechurch Securities’ Ben Willis said. “If bond markets react very negatively, then liquidity will be a real issue.”
“As such, to mitigate against this risk, we have either moved into strategic bond funds, where the manager has the flexibility to defend the portfolio against such a scenario and the universe of fixed interest assets to add value/tap liquidity; or we have moved our investment grade exposure into a smaller, more nimble fund that does not have the multi-billion pound problem of the successful funds.”
Therefore, given Hodges has a lot of experience in bond markets, has an unconstrained strategy and is running a very small fund, Willis says Nomura Global Dynamic Bond is a fund investors should keep an eye on.
“We have invested with Hodges in the past when he was running the L&G fund. He is a manager that we rate, though his track record does indicate some periods when he positions the portfolio incorrectly and underperforms.”
“However, he has long-term experience of the fixed interest market and clearly understands the nuances of bond investing.”
Nomura Global Dynamic Bond, which also holds 33 per cent in BB-rated credit and has a relative overweight in convertible debt, has an ongoing charges figure of 1.2 per cent.