The recent turmoil in the bond market sparked by renewed fears around the eurozone has shown the value of holding lower volatility Strategic Bond funds, says Rathbones' Bryn Jones.

The Rathbone Strategic Bond fund was launched in October 2011, just as the debt crisis had reached a crescendo, to provide investors with a means of outsourcing their fixed interest investment allocation.

"Our framework now is a core strategy of seven different indices with 10 per cent strategic asset allocation overlay with a 10 per cent strategic allocation either side of the index. We found that this allocation model can increase returns without increasing volatility," said Jones.

According to data from FE Analytics, the fund has returned 5 per cent since launch, underperforming the peer group by 2 percentage points. However, Jones believes that these figures cover up the strength of the underlying fundamentals.

Performance of fund since launch vs sector



Source: FE Analytics

"The vast majority of the funds in the sector are little more than high yield bond funds in disguise," Jones added. "Against the backdrop of the LTRO the high yield credit funds have performed well. Our fund has held its own in this market but as the problems with Spanish and Italian bond yields have emerged, our fund is starting to outperform. When we get these big shake-outs in markets like we did last summer, this fund should do well."

"Our investors hold the fund because they want a bit of gilt exposure, a bit of corporate credit and a bit of access to global credit markets, but want someone else to manage it."

"After a couple of cycles and a bit of volatility we expect the strength of the strategy to be shown. After all, the VIX [nicknamed the fear index] has traded at lows recently."

Jones and co-manager David Coombs do not invest directly in the high yield credit market, preferring instead to hold collectives such as the Kames High Yield Bond fund for their exposure in that space.

The managers say this has the benefit of increasing liquidity while outsourcing their investment decisions to the best managers at a fraction above the cost associated with direct exposure.

The key area where Jones is adding Alpha is through direct exposure to lower tier-two bank debt. The fund has 7.5 per cent of its assets in these certificates, a significant overweight compared with the rest of the sector.

"This is a strong theme we’re playing. We look for notes with a call date coming up. As an example, JP Morgan has a note with a yield-to-call ratio of 60 per cent. If it doesn’t call then we don’t care because we still get paid 8 or 9 per cent, and if they do call then we’re laughing all the way to the bank. The LTRO has meant that some of these notes will get called by the debtors because they can afford to borrow at a much cheaper rate via the LTRO."

Jones says the risk of default is mitigated by regulation because debtors are not allowed to defer call dates on these certificates.

"In tier-one land this strategy might be a little bit more high risk but we’ve been happy to wear the volatility hammering this theme out. At a time when interest rates are low you have to take some volatility to get a yield. Bonds no longer have an inverse relationship to equities."

The Rathbone Strategic Bond fund has a degree of flexibility to pursue this theme because it is designed as a low volatility product. Data from FE Analytics shows its annual volatility score is 4.34 per cent, only slightly higher than the sector average of 3.7 per cent.

Jones finished by saying: "Investors cannot afford to be sanguine towards their fixed interest allocation. There is no leverage in the system and the risk-on/risk-off trade is really threatening liquidity."