Strategic Bond sector allows funds to invest across fixed interest spectrum, causing popularity to soar above corporate bonds
Strategic bonds have soared in popularity this year, with investors attracted by their ability to invest across the fixed interest spectrum in what has been a volatile period for markets.
Strategic Bond topped the IMA’s list of bestselling retail fund sectors four times in the first six months of 2010, with inflows peaking at £476m in March.
By contrast, demand for corporate bonds has declined significantly, with the £ Corporate Bond sector suffering outflows in January, February and May totalling £532m.
The IMA £ Strategic Bond sector includes 64 funds with a remit to invest at least 80% of assets in sterling-denominated (or hedged back to sterling) fixed interest securities.
Strategic Bond differs from the IMA £ Corporate Bond sector in that it gives fund managers the ability to take more strategic decisions by investing across the sterling fixed interest markets.
The average fund in the Strategic Bond sector gained 15.3% over the year to 9 August, according to Morningstar. George Luckraft’s Axa Framlington Managed Income fund is the top one-year performer, posting a gain of 33.7%. The worst performer over one year is UBS Active Bond, up 4.2%.
Henderson manages four funds within the Strategic Bond sector under John Pattullo, the head of retail fixed income.
Henderson High Yield Monthly Income, Preference & Bond, and Henderson Fixed Interest Monthly Income all feature within the top 10 performers over one year, up 27%, 23% and 21% respectively.
The fourth, Pattullo and Jenna Barnard’s Henderson Strategic Bond, is one of the pioneering funds in the sector. Launched in October 1999, strong investor interest on the back of solid performance through the 2008 downturn has helped the vehicle grow to £899m from just £300m at the beginning of 2009.
Over five years, the fund is ranked third out of 43 vehicles, up 28.4% compared to an average increase of 15.7%. Over one year it is up 17.2%.
Barnard believes the trend of fund flows shows investors are looking for vehicles to help them navigate a challenging macroeconomic environment.
She says: “At a time when the risks to economies and government bonds seem so binary, in terms of inflation and deflation, it makes sense to invest in bond funds that have the flexibility to actively asset allocate within the bond market and react to changing economic and corporate newsflow.”
The manager adds: “With credit spreads at current levels, investment grade corporate bond fund returns will predominantly be driven by the performance of the gilt market.”
Barnard says the performance of Henderson Strategic Bond year to date largely reflects the income yield on the portfolio.
“The capital values of the bonds we hold have been volatile and thus income has been a key contributor to returns,” she says.
“Within the credit market, we have had a preference for higher yielding, more default-sensitive parts of the market in the form of subordinated financial bonds – Tier 1 predominantly – and high yield corporate bonds. These assets have performed strongly.”
The manager admits sovereign bond hedges in the form of interest rate futures and swaps have detracted from performance due to the better-than-expected performance of gilts year to date.
Barnard says the portfolio has been positioned long credit risk and short government bond risk for over a year.
She says: “We have tended to be better sellers of investment grade corporate bonds, which have a high sensitivity to the underlying gilt, and better buyers of high yield corporate bonds where a number of attractive new bonds have been issued this year.
“The gilt short has been reduced somewhat and cash is currently at a relatively high level, looking for opportunities to invest should markets suffer another bout of weakness.”
George Luckraft believes investors’ move into strategic bonds has happened because, as the world economy has improved, people have generally increased their risk profile to try to obtain more yield.
The manager says Axa Framlington Managed Income had a “horrible time” going into the credit crunch. He admits he made a strategic mistake by splitting the fund between investment grade financials and sub-investment grade.
“The sub-investment grade all got killed in risk aversion and we all know what happened with financials. The fund had a terrible time and had redemptions through that process,” Luckraft says.
He took the view the financial system would have to be bailed out and held his positions in the sector.
“I stuck with them on the basis a lot of mandates in fixed income are run on the basis they are very strictly governed by the ratings,” he says.
“So if it gets downgraded you get a lot of forced sellers and I thought that was just a mad thing to do – to be selling alongside everyone else.”
As he had funded redemptions from elsewhere in the portfolio, the manager increased exposure to financials and they bounced back very strongly.
“A classic example is a long-dated Legal & General bond. I paid par for it, and at the bottom of the crisis they were trailing at 25p in the pound,” he says.
“They are now back up in the mid 80s, and the interesting thing for me – because I run equities as well – is that for once the equity led the bond.
“The equity price started rallying before the bond. This was because there was still quite a lot of churn as people were forced sellers, trying to get risk off the table,” he adds.
“So you got to the stage where yields were just incredibly attractive, and I had the nerve to stick with it and this has proved very right.”
Another strong performer in the sector is the Baillie Gifford Corporate Bond, ranked third over one year, with a return of 23.7%.
The Baillie Gifford Corporate Bond is a stockpicking fund with a split of 70% in investment grade bonds and 30% in high yield.
Co-manager Stephen Rodger says: “This is quite a good blend to immunise yourself from the peaks and troughs, depending on which market rallies and which one sells off.”
Strong performers identified by Rodger include money lender Provident Financial, which is the largest position in the fund’s top ten holdings, accounting for 3.2% of the portfolio at 30 July.
Another is Standard Life Bank, which is the second largest holding at 3%.
Rodger says: “Standard Life has non-performing loans, which form about 0.2% of its book, which is microscopic. It was sold to Barclays, and because Standard Life was exiting the business, a bond that was sold off became very high yielding.”
He says the market has not really woken up to the fact Standard Life is now owned by Barclays.
“We were able to buy these bonds yielding variously 1% to 1.5% more than Barclays paper,” Rodger says.
“At the moment, they are still cheap relative to other Barclays paper because we still have brokers out there in our world putting these
on their insurance lists rather than their Barclays banking lists.”
