The strat bond funds that have made money in gilt sell-offs

Six funds from the IA Sterling Strategic Bond sector have achieved positive returns during four of the biggest gilt sell-offs in this cycle so far, according to research from FE Trustnet.

Last week saw 10-year gilt yields rise to more than 1 per cent, which could have been caused by overseas investors selling their assets in light of a plummeting sterling.

With 10-year gilt currently yielding 1.09 per cent and 30-year gilts at 1.76 per cent, yields have almost doubled over two months following a prolonged period of plummeting yields as investors flocked to the asset class for safety.

Performance of indices over 5yrs

Source: FE Analytics

While some believe this is a temporary blip and that gilt yields will remain low over the longer term, others are less certain and believe this could be the start of bond volatility continuing to trend upwards.

In an article published last Thursday, FE Trustnet covered a report from Pantheon Macroeconomics which says gilt yields are likely to keep rising over the medium term.

It says this is due to increased inflation expectations from markets – which haven’t been fully priced in yet – and the likelihood that gilt yields will rise along with US treasury yields next year.

“All told, we still think that gilt yields will trend up over the next couple of years, despite weakness in the economy,” the report stated.

“We expect 10-year yields to rise to around 2 per cent by the end of 2017 and to 2.8 per cent by the end of 2018.”

Given concerns that fixed income could remain volatile for some time yet, we focused on four short, sharp and significant corrections in the Barclays Sterling Gilts index over the current market cycle.

The first occurred between November 2010 and February 2011 as investors regaining some confidence after the financial crisis but before the eurozone sovereign debt crisis emerging; the second happened between April and September 2013 as a result of the ‘taper tantrum’; and the third occurred between February and June last year when equities and bonds sold off in tandem.

The fourth sell-off we focused on started in August this year and is still continuing, meaning that it currently covers a period of just two months.

Performance of indices vs sector over 10yrs

Source: FE Analytics

Using FE Analytics, we took a look at all of the funds in the IA Sterling Strategic Bond sector that had managed to beat the Barclays Sterling Gilts index over each of these time frames. Of course, investors should bear in mind that past performance is no guide to future returns.

The results were surprisingly positive, with a total of 50 funds passing through this filter.

To narrow it down further, FE Trustnet then removed all funds that had made a loss over any one of these periods and found that six remained, as shown in the table below.

Table of funds’ returns and sector ranking during each sell-off

Source: FE Analytics

The top-performing fund from the table over both the European debt crisis and the current sell-off is Royal London Sterling Extra Yield Bond, which has three FE crowns and is headed up by Eric Holt.

During 2011’s sell-off it returned 2.27 per cent - placing it top in its sector – compared to its average peer’s loss of 1.65 per cent and the Barclays Sterling Gilt’s loss of 4.18 per cent.

In this year’s pullback, it has outperformed the gilt index and its sector average by 6.4 and 1.55 percentage points respectively with a return of 1.04 per cent.

The £1.3bn fund aims to achieve a gross redemption yield at least 1.25 times higher than that of its FTSE Actuaries British Government 15 Year index.

Given this mandate, Royal London Sterling Extra Yield Bond has its largest weighting in bonds rated BB or below at 43.1 per cent and holds just 2.5 per cent in A, AA, or AAA-rated bonds. As such, it is no surprise that it has managed to achieve strong returns when gilts are suffering.

Not only does it have a top-quartile maximum drawdown (which measures the most potential money lost if bought and sold at the worst possible times) over the last five years, it has also achieved a better-than average downside risk (which predicts a fund’s potential to fall during down markets) over the same time frame.

The fund is also in the top quartile for its total returns over three, five and 10 years.

However, it’s important to note that while it has held up in times of gilt stress, it is inherently more risky due to its focus on high yield bonds. Since inception, its maximum drawdown has been the sector’s second highest at 43.60 per cent (which occurred during the financial crisis) while its annualised volatility is also the second highest.

Over the second gilt sell-off we looked at, Artemis High Income achieved the highest return out of all the funds in the aforementioned table for similar reasons. It delivered the best performance out of every fund in the sector at the time with a total return of 2.95 per cent compared to its sector average’s loss of 2.1 per cent and the Barclay Sterling Gilt index’s fall of 6.16 per cent.

To provide investors with above-average and growing income, manager Alex Ralph invests predominantly in corporates, with the likes of Centrica, BAE Systems and BHP Billiton residing in her list of top 10 holdings.

She currently holds no AAA-rated bonds and AA bonds account for 3.9 per cent of the portfolio’s entire fixed income allocation. She also has 1.4 per cent in A-rated bonds while B-rated bonds account for more than a quarter of the bond allocation in the portfolio.

The £1.1bn fund is unusual for strategic bond fund in that it tends to maintain an allocation in equities – these currently account for 13 per cent of the portfolio while government bonds only account for 4.2 per cent.

As such, the fund is more volatile on an annualised basis than its average peer over five years. It is in the bottom quartile for its maximum drawdown over this time frame.

It has achieved strong total returns over this time though, having outperformed its sector average by 26.55 percentage points with a gain of 63.03 per cent.

Performance of fund vs sector over 5yrs

Source: FE Analytics

While Ralph has only been sole manager of the fund since 2014, she co-managed the investment vehicle alongside former longstanding managers Adrian Frost and Adrian Gosden for two years before Frost stepped down and Gosden left the firm earlier this year. 

During last year’s gilt market correction, TwentyFour Dynamic Bond took the top spot out of the funds in the table for its total return of 2.39 per cent, putting it in seventh place out of the whole sector. While the fund returned 2.39 per cent, its average peer lost 1.29 per cent and the gilt index lost 6.75 per cent.

The fund is £1.5bn in size and is able to invest across the whole range of the fixed income market – the management team aren’t afraid to buy into high yield as well as investment grade, government bonds, asset-backed securities and emerging market sovereign bonds.

It is also able to use derivatives to optimise or reduce any exposures within the portfolio and can also hold short as well as long positions.

The team utilise this to follow an absolute return mandate, aiming to provide attractive income as well potential capital growth across all market conditions.

Over the last five years, TwentyFour Dynamic Bond has achieved a total return of 54.27 per cent compared to its sector average’s return of 36.48 per cent and its LIBOR GBP 3 Month benchmark’s return of 3.13 per cent.

Performance of fund vs sector and benchmark over 5yrs

Source: FE Analytics

However, it is in the bottom quartile for its annualised volatility and maximum drawdown over this time frame, suggesting it may not be best-suited to the more cautious investor.