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Bambos Hambi: Why strategic bond funds won’t make money as rates rise

04 December 2015

The Standard Life Investments multi-manager holds absolute return bond funds as he argues they are the only kind of bond portfolio that will generate positive returns when central banks hike interest rates.

By Gary Jackson,

Editor, FE Trustnet

Strategic bond funds lack the necessary flexibility to make positive returns when the Federal Reserve and Bank of England start to increase interest rates despite many investors looking to this sector as a defensive bet, according to Standard Life Investments’ Bambos Hambi.

Speculation over the future direction of the bond market is rife, as the Federal Reserve and Bank of England look to make their first interest rate rises since the global financial crisis. However, the European Central Bank and Bank of Japan remain very much in loose monetary policy mode.

Performance of indices over 6yrs

 

Source: FE Analytics

In an article yesterday, Schroders head of multi-manager Marcus Brookes warned that falling bond dealer inventories – which have dropped 85 per cent despite outstanding debt doubling since the crisis – is creating a worrying situation should investors try to move away from the asset class.

“If you thought it was bad, it's actually worse than you thought it was,” he said. “It doesn’t matter at this moment in time because markets are OK, there's no shocks and no expectations of a recession, but this thing will come to roost at some point in the next two years. I just don't know exactly when.”

Against this backdrop, many investors have been opting for strategic bond funds as they have greater flexibility to move between different parts of the bond market in search of the best opportunities.

However, Hambi says even these funds are heading for losses in the event of a rate hike and argues that absolute return bond funds offer a better hunting ground for the more cautious investor.

“To us, strategic bond funds do have a function but if you get a big sell-off in your UK government bond exposure, if interest rates rise quite dramatically over the next couple of years, then they will be hurt and they are not going to be able to make money as interest rates goes up. They will be able to protect on the downside to some extent, but they won't make money,” he said.

“Strategic bond funds allocate between government, investment grade and high yield bonds but if interest rates go up, all these areas will lose money. We want something that gives us much more flexibility and have many more tools in the box. We don't have any strategic bond funds in our portfolios - it's either high yield bonds, UK government or index-linked, corporate bonds or absolute return.”

“With the absolute return bond funds we're interested in, we're looking for returns of cash plus 2 or 2 per cent with much, much lower volatility than equities. If you get the right fund, when interest rates go up and bond markets start to struggle, they should be in a position to make money from that.”


 

There are around 20 funds in the Investment Association universe that describe themselves as being ‘absolute return bond funds’. Our data shows that the average portfolio using this approach has underperformed the IA Sterling Strategic Bond sector over five years from a total return point of view after making 8.43 per cent.

Performance of sectors over 5yrs

 

Source: FE Analytics

However, absolute return bond funds significantly outperform when it comes to defensive metric, posting annualised volatility of 1.62 per cent over the same five years and a 1.70 per cent maximum drawdown; strategic bond funds have had annualised volatility of 3.77 per cent and a 3.72 per cent maximum drawdown.

Looking at a period of bond market stress also demonstrates absolute return bond funds’ ability to defend capital well.

During the ‘taper tantrum’ that spanned 22 May 2013 to 25 June 2013 the Barclays Sterling Gilts index fell 3.66 per cent while the average strategic bond fund lost 4.38 per cent but the average absolute return bond fund was down just 1.80 per cent.

What’s more three of the funds – Ignis Absolute Return Government Bond, Insight Absolute Insight Credit and LO Funds Absolute Return Bond – remained in positive territory over the period in question.

While past performance is no guide to the future, Hambi thinks funds of this kind will be able to find opportunities even if bond markets sell-off strongly. However, he says that research into them is essential as many investors might not be comfortable with their use of swaps and “other exotic instruments”.

“I have two members of my team that go through them with a fine-tooth comb,” he said. “We meet the managers multiple times [before we invest] and spend a lot of time looking at their systems and administration.”


 

The manager currently holds two such funds in his portfolios. Standard Life Investments Absolute Return Global Bond Strategies is used in his fettered MyFolio Managed range while the offshore BNY Mellon Absolute Return Bond fund is owned in his unfettered MyFolio Multi Manager range.

Performance of funds vs sector and index over 3yrs

 

Source: FE Analytics

The Standard Life Investments fund is run by the firm’s multi-asset team, which also manages its successful Standard Life Investments Global Absolute Return Strategies fund. It aims to make a cash plus 3 per cent return in all market conditions over rolling three-year periods.

BNY Mellon Absolute Return is managed by a team from BNY Mellon affiliate Insight Investment Management, which is a specialist in absolute return investing. Hambi has a degree of familiarity with the managers, having worked alongside the majority of the team during his time at Rothschild Asset Management.

As the graph above shows, both funds have provided a higher total return than the average absolute return bond fund over the past years. In addition, while they have lagged the Barclays Sterling Gilts index, both have given their investors a much smoother ride, with less volatility and a lower maximum drawdown.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.