It’s been a difficult year for most bond investors as the usually ‘safe’ asset class has delivered high levels of volatility and large drawdowns. 
Many also expect this sort of return profile to worsen as we finally enter an interest rate rising cycle in the US and UK, which may turn out to be a painful period for those invested in fixed income.
Of course, some will just be avoiding bonds altogether within their portfolios but many still need the diversification benefits they can offer. This is a challenge that Chris Metcalfe and his team at IBOSS have had to face for a number of years now as they run various risk-targeted portfolios which are outsourced to advisers.
However, Metcalfe – who is investment director at the white label company – is confident on the eight fixed income-related funds he uses as he believes they can offer an effective low-volatile blend.
“It’s quite an unorthodox mix. The performance hasn’t been stunning but it has done well compared to other bond funds,” Metcalfe (pictured) said.
Performance of portfolio versus sectors in 2015
Source: FE Analytics
“Our goal is to deliver low volatility [within the bond segments of the portfolios] which isn’t a complicated one. We are trying to say to advisers, this is what we are aiming to do. Some people will say they are running to cash and all the rest of it, but we can’t run to cash because we run adviser portfolios.”
“We wouldn’t do anyway, because we would just get whipsawed to death and take everybody with us.”
In this article, Metcalfe runs through the eight funds he uses and what part he wants them to play within his portfolio.
Premier Defensive Growth & Insight Absolute Insight – for non-correlated returns
Of course, neither Premier Defensive nor Insight Absolute Insight are strictly bond funds as both sit in the IA Targeted Absolute Return sector.
However, Metcalfe says investors can no longer rely on traditional government bonds to protect their portfolios given the historically low yields on offer and is therefore looking for more ‘alternative’ funds for non-correlated returns to equities.
“They are not correlated to other bond funds which is good because if bonds and equities can go up together (as they have) then they are highly correlated, at times. Therefore, they can go down together but these funds are not correlated,” Metcalfe said.
The five crown-rated Premier Defensive Growth fund has been managed by Paul Smith since launch and aims to deliver positive returns on a rolling annual basis by investing across a broad range of long only assets.
FE Alpha Manager Sonja Uys’ £861m Insight Absolute Insight fund aims to deliver the same return profile but by blending six other absolute return portfolios which are managed in house by Insight.
According to FE Analytics, Insight Absolute Insight has returned 6.76 per cent over three years while the Premier fund is up 10.51 per cent.
Performance of funds versus indices over 3yrs
Source: FE Analytics
While they have both underperformed gilts and corporate bonds over that time, they have had maximum drawdowns of less than 1.2 per cent over that time compared to more than 5.5 per cent from the two indices.
M&G UK Inflation-Linked Corporate Bond & Insight Inflation-Linked Corporate Bond – for inflation protection
Metcalfe admits that many advisers have questioned his decision to use these two funds given they have both underperformed relative to their peers in the IA Sterling Strategic Bond sector over recent years.
However, he says these funds are there to add another layer of protection as they should grind out a smooth return and can defend investors against a sharp sell-off in the market.
“Our central case, and this hasn’t really changed, is that the world is trying to create growth. That means there are two scenarios – it creates growth which will then create inflation or it doesn’t and we are all stuffed so no matter what you invest in, its game over,” Metcalfe said.
“On the positive side, if it is plan ‘A’ and we create growth and therefore inflation, these assets are going to come through and they offer protection, at the end of the day.”
Like the Premier and Insight funds, Metcalfe points out that both M&G UK Inflation-Linked Corporate Bond and Insight Inflation-Linked Corporate Bond offer uncorrelated returns to large parts of the fixed income market.
The £718m M&G fund is headed up by Ben Lord and has returned 11.79 per cent since its launch September 2011 (which has been above the rate of inflation) and has had a maximum drawdown of 4 per cent.
David Hooker’s Insight fund was only launch in February 2013, but it to has delivered a return in excess of the Consumer Price Index.
M&G UK Inflation-Linked Corporate Bond currently yields 0.15 per cent while Insight Inflation-Linked Corporate Bond’s yield is higher at 2.78 per cent.
TwentyFour Dynamic Bond & Artemis Strategic Bond – For active exposure
The four previous funds mentioned are there to play a very defensive role for Metcalfe, so he also wants managers who can take advantage of potential opportunities within the bond market.
Many market commentators have told FE Trustnet that in order for investors to see an attractive return from bond funds over the coming few years, there best bet is to hunt within the IA Sterling Strategic Bond sector as managers in the peer group have a high degree of flexibility.
Metcalfe agrees with this sentiment and is therefore using the highly-rated TwentyFour Dynamic Bond and Artemis Strategic Bond funds to try and generate alpha for his clients.
“They are both very active, especially the TwentyFour guys,” he said.
The five-crown rated Artemis Strategic Bond fund is co-managed by Alex Ralph and James Foster. It currently yields 4.2 per cent thanks to a high weighting to BBB, BB and B-rated credit. The fund is outperforming the sector over one, three, five and 10 years.
The £1.4bn TwentyFour Dynamic Bond fund has shorter track record but also carries five FE Crowns.
Performance of fund versus sector since launch
Source: FE Analytics
FE data shows the fund is comfortably top-quartile since its launch in April 2010 and has the third highest alpha generation score in the peer group over that time. It currently yields 4.45 per cent as the managers are running a blend of assets, such as investment grade credit, corporate bonds, sovereign debt, insurance and asset-backed securities.
Baillie Gifford Corporate Bond & Rathbone Ethical Bond – for bottom-up stock-picking
The final tranche of Metcalfe’s portfolio is dedicated to bottom-up stock-picking funds and for that exposure he uses Bryn Jones’ Rathbone Ethical Bond fund and Baillie Gifford Corporate Bond, which is managed by Stephen Rodger and Torcail Stewart.
The reason he likes these funds in particular is that they purely focus on each bond’s fundamentals, rather than many of their peers who aim to outperform by tinkering with duration – which measures sensitivity to interest rate movements.
“They don’t do duration. We kept using it as a backstop because Torcail Stewart and the team are very good at stock-picking so they are not playing duration while all the other managers are, to one degree or another.”
“Despite the fact we wanted that Baillie Gifford fund to be last in the sector, it wasn’t. Actually, duration has worked against everyone who was trying to play it because everyone was on the wrong side of it.”
“Even though all the fundamentals said, ‘it should be x’, it wasn’t, it was y. The fact that, by default, Baillie Gifford don’t play duration it meant our portfolio got some protection.”
Despite its name, Baillie Gifford Corporate Bond sits in the IA Sterling Strategic Bond sector and has outperformed over one, three, five and 10 years.
Performance of fund versus sector over 10yrs
Source: FE Analytics
While it sits in the sector’s third quartile for annualised volatility over the past five years, Baillie Gifford Corporate Bond has delivered top quartile alpha generation and risk-adjusted return (as measured by its Sharpe ratio).
The fund yields 3.8 per cent and is made up of 97 holdings. Typically, the managers will hold 70 per cent in investment grade bonds and 30 per cent in high yield.
