With concerns about a more difficult period for core government bonds, a recent FE Trustnet article highlighted that funds within the IA Sterling Strategic Bond sector have tended to offer bond investors protection during periods of rising gilt yields. 
Though government bonds have performed strongly in 2016, prices have started to fall over recent weeks and the likes of Miton’s Anthony Rayner and AXA IM’s Chris Iggo warn the asset class could continue to be a source of volatility as valuations are still too high and central bank policies are losing their effectiveness.
Our research found, however, that the average fund in the IA Sterling Strategic Bond sector – a popular area for more nervous fixed income investors who want managers with a greater level of flexibility in their portfolios – has tended to perform well when government bond yields have risen in the past.
According to FE data, for example, the sector average has had a downside capture ratio relative to the FTSE Actuaries UK Conventional Gilts All Stocks index of -9 per cent over five years – indicating the peer group has tended to make a positive return on average when the gilt index has fallen in value.
On top of that, we found that there have been eight funds in the sector that have made a positive return in each of the six periods over the past five years when the index has posted a drawdown of more than 3 per cent.
Best performing strategic bond funds when gilts yields have risen
Source: FE Analytics
As mentioned in the article earlier today, here we highlight three of the funds (that are widely available to investors) that have delivered the highest and most consistent returns during those periods – GAM Star Credit Opportunities, Artemis High Income and TwentyFour Dynamic Bond.
First on the list is FE Alpha Manager Anthony Smouha’s five crown-rated GAM Star Credit Opportunities, which has delivered an average return of 5.88 per cent over the last six periods that the FTSE Actuaries UK Conventional Gilts All Stocks index has posted a drawdown of more than 6 per cent.
On top of that, the five crown-rated fund has had the lowest downside capture ratio in the peer group relative to the index over five years of -130 per cent.
The fund’s performance during periods of rising gilt yields stems from Smouha’s approach to the fixed income market.
His process is to focus on high credit-rated issues, but invest in bonds further down those companies’ capital structure. In essence, he aims to invest in companies that shouldn’t go bust but pick up a higher yield and therefore will have benefitted from a carry trade in the fixed income market.
This focus on higher yielding bonds has also helped GAM Star Credit Opportunities longer term total returns.
According to FE Analytics, the fund – which currently yields 4.48 per cent – has been the best performer in the sector since its launch in July 2011 with returns of 71.84 per cent, meaning it has far outpaced the gains of its Barclays Sterling Aggregate benchmark in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
Clearly, the past is no guide to future returns and there is no telling whether GAM Star Credit Opportunities will be able to keep delivering positive returns during periods of rising gilt yields.
However, one reason why yields would naturally rise is if the economy starts to pick-up and Smouha holds bonds issued by more cyclical companies in his portfolio. Indeed, he holds debt issued by Lloyds, BHP Billiton, Aberdeen Asset Management and Legal & General in his top 10.
Second on the list is the £1.1bn Artemis High Income fund, managed by Alex Ralph.
It has posted an average return of 4.99 per cent over the past six periods the gilt index has fallen by more than 3 per cent. Again, it has been Ralph’s preference for higher yielding names which has helped this performance profile.
Artemis High Income is also one of a number of funds that has had a structural weighting to equities (the current weighting is 13 per cent) and given the fact government bonds and company shares have tended to be uncorrelated or negatively correlated over the years, this has helped the fund during times of wider bond market stress.
The fund currently yields more than 5.5 per cent, which is generated due to Ralph’s 93 per cent exposure to BBB or lower rated debt in her bond allocation.
Like with the GAM fund, this sort of positioning has aided performance with Artemis High Income the second best performing portfolio in the IA Sterling Strategic Bond sector over five years with returns of 62 per cent.
Performance of fund versus sector over 5yrs
Source: FE Analytics
While it has produced some of the best risk-adjusted returns in the peer group over that time, its focus on higher yielding bonds and equities will have no doubt have led to its bottom decile maximum drawdown over five years.
Square Mile rate the fund highly, though admit it isn’t an offering for highly risk-averse investors.
“Given its focus on yield, the fund is likely to have a relatively aggressive return profile, tending to outperform in times of strong corporate bond returns, but lag when corporate bonds are falling,” Square Mile said.
“This profile is likely to result in considerable capital volatility at times, although we believe that, over longer time periods, this more aggressive approach will produce good results.”
The final fund is arguably the most diversified of the three, given that the managers invest across all areas of the fixed income market including government bonds, investment grade credit, high yield bonds, insurance and asset-backed securities.
The £1.5bn TwentyFour Dynamic Bond, which is run by a highly experienced four-strong team, has posted an average 4.73 per cent returns in each of the last six times gilts have lost more than 3 per cent in value.
While it invests in all areas of the bond market for opportunities, these returns have no doubt been down to the managers’ preference for higher yielding areas of the fixed income space and shorter duration assets. Indeed, TwentyFour Dynamic Bond has a yield of 4.88 per cent today with high weightings bank debt and European ABS.
It is a fund that is highly rated by asset allocators (FE Trustnet revealed it was the most popular bond portfolio with fund of funds managers) and its returns over recent years explain why.
Our data shows, for example, that it has been a top quartile performer over the past five years and has tended to deliver better relative returns during more difficult times for credit markets – such as in 2013 and 2015.
Performance of fund versus sector over 5yrs
Source: FE Analytics
It has tended to be more volatile than its average peer, as demonstrated by its large drawdown during 2011 when the European sovereign debt crisis intensified. This can be part and parcel of a fund aiming for a higher than average yield, though, and the managers have been rotating their portfolio recently for that reason.
“Following the very strong rally in UK gilts during the summer and after increasing the holdings in investment grade bonds at the start of the month, the managers took the decision to take profits on some of the gilt holdings,” TwentyFour said.
“While UK government bonds are not expected to experience a significant correction from here, given the clear support from the BoE, a catalyst is probably needed to drive yields lower (10-year gilts now yield just 70bps) and better income is available in other sectors.”