Architas manager Caspar Rock explains the key considerations of strategic bond investing
Where do they come from?
The IMA sectors were introduced to help investors make comparisons between funds with similar characteristics, but in order to keep up with the innovation in the fund industry, the trade body conducted a thorough review of its fixed income sectors to ensure they represented an appropriate classification system for a whole array of bond funds with many different characteristics.
As a result of the review, the IMA split what were known as the UK Corporate Bond and UK Other Bond sectors into three new sectors: Sterling Corporate Bond, Sterling Strategic Bond and Sterling High Yield.
This new grouping came into effect in September 2008, following consultation with IMA member firms and the Association of British Insurers, to achieve a more consistent categorisation.
Due to the investment freedoms of the recently implemented strategic bond group, Architas strongly believes investors need to fully understand the flexible nature of the sector. In contrast to its other sectors, the IMA’s Strategic Bond sector does not have any constraints on asset allocation across debt markets. In fact, this sector only has one necessity – funds must invest 80% of their assets in sterling-denominated (or hedged back to sterling) securities.
Therefore, the characteristics and asset allocation of the constituent funds could change at any time and could closely resemble another IMA fixed income sector. For example, the economic and market backdrop may dictate a bias to government and high-quality investment grade bonds, whilst an improvement in financial conditions later in a quarter could warrant a rapid switch to more aggressive exposures.
Why the change?
Prior to these changes, the UK fixed income sector was mainly divided by credit rating criteria and the type of debt in which a fund could invest. This was all very well when bond funds predominantly stuck to distinct areas of their universe and did what they said on the tin.
In other words, a fund in the old IMA UK Corporate Bond sector would invest the majority of its assets in bonds with a minimum credit rating of BBB- (Standard & Poor’s or an equivalent rating agency). Funds which were less clear cut may have fallen into the no longer existing IMA Other Bonds sector, where they would need to invest at least 20% of their assets in debt with a credit rating of less than BBB- which could include convertible bonds and income producing preference shares.
The arrival of the Ucits III, aimed at enhancing investment flexibility, enabled fund houses to develop products which could invest across a wider range of asset classes and sectors. One of the biggest impacts was expanding the use of derivatives for ‘investment purposes’ rather than just hedging, which was allowed under the previous regime. This development, together with other investment freedoms, helped propel the meteoric rise of ‘strategic’ bond funds.
What is a strategic bond vehicle?
While bond fund managers embraced these wider powers, many investors and financial advisers were left wondering what exactly constitutes a strategic bond fund.
The new breed of fixed income investing was touted as ‘adding value in all markets’, but often investors were unclear as to how performance would be pursued and against what benchmark. In terms of classification, historically these funds generally sat with the high yield corporate bond funds into the now redundant IMA Other Bonds sector.
The IMA’s new fixed income sector definitions aim to provide more clarity between the different types of UK bond funds, whilst recognising that many fund managers are taking full advantage of the flexibilities offered by Ucits III.
So what are the key considerations now?
The IMA Strategic Bond sector’s constituent funds have the freedom to target the widest set of opportunities across the fixed income universe – in other words, fund managers can invest wherever they perceive the most value. Architas believes this is a very positive development; however, investors should be aware of the heterogeneous nature of the strategic bond sector.
Key consideration one – asset allocation
Strategic bond funds are permitted to invest in a whole spectrum of debt instruments, including government bonds, inflation-linked securities, investment-grade and higher yielding credit and emerging market bonds. Given this level of flexibility, at any point in time, the asset allocation of strategic bond funds may theoretically place them in one of the IMA’s
While the requirement that funds invest at least 80% of their assets in sterling-denominated (or hedged back to sterling) securities remains, funds in the IMA’s Sterling Strategic Bond sector are no longer constrained by credit rating criteria and can also invest in a variety of ‘hybrid debt’ securities, including convertible bonds, preference shares and permanent interest-bearing shares.
Part of the IMA Strategic Bond sector, the Architas Cautious Income fund can potentially target opportunities across the full spectrum of fixed income markets. At present, a significant proportion of the fund invests in a complementary blend of investment-grade credit funds, which have been carefully selected to ensure we target a range of strategies, from conservative through to more aggressive exposures. Our global bond exposure is also a significant weighting – we allocate to both index-linked and conventional government bond funds that target issues all over the world.
In addition, we invest in sub-investment grade credit, currently via funds that focus on higher quality issues, along with convertible bonds, absolute return and emerging market debt funds. Our aim is to maximise the sources of income, whilst diversifying risk across a range of markets.
Key consideration two – benchmark
There are very few benchmarks common to the 64 funds which currently make up the IMA Sterling Strategic Bond sector. Typical fund benchmarks include Merrill Lynch Sterling Broad Market index, iBoxx Sterling Non-Gilt index, FT British Government All Stocks index or a cash plus index, such as Libor +3%.
Therefore, when examining relative returns, a fund could be underperforming its benchmark, but delivering superior gains compared to some of its peers benchmarked against a different index.
Conversely, a fund could be lagging its peer group, but outperforming its benchmark due to the potentially large differences in asset allocations across the sector.
While Architas Cautious Income is included in the IMA Strategic Bond sector, we reference performance against a benchmark consisting of 50% investment-grade credit, 40% government bonds and 10% high yield bonds.
In addition, the sector includes some funds which tend to invest the bulk of their assets in sub-investment grade debt, but are attracted to the flexibility of the IMA Strategic Bond sector which will allow them to take refuge in government bonds or high quality corporates in market downturns. Therefore, it could be expected that these investments with a bias to high yield will be more volatile than some of their peers.
Key consideration three – investment strategies
Given the sheer breadth of investment scope permitted by the IMA Strategic Bond sector, managers can pursue a broad range of strategies to add value. Performance could come purely from credit selection between investment-grade and sub-investment grade corporate bonds, with duration tending to be in line with the benchmark. Or, potential excess returns could come partially from credit selection and tactical duration exposures. To varying degrees, strategic bond funds may also seek alpha from a number of other sources, including various currency exposures, relative value trades, yield curve steepener or flattener positions.
Key consideration four – derivatives
The use of derivatives also varies considerably across funds in the sector. Prior to Ucits III, fund managers could only use derivatives to hedge. Funds which have taken up the wider powers, permitting derivatives to be used for ‘investment purposes’, can use these instruments for expressing directional opinions without taking a direct position in the underlying asset as well as hedging purposes. Using derivatives may be a less risky, but a more liquid and cost-effective way of replicating a position in a particular area of a market rather than investing directly. Funds using the powers can also use derivatives to gain from expected fall in investment values – for example, in response to expected credit deterioration – and to manage duration.
Importantly, not every fund in the strategic bond sector has adopted wider powers; therefore, the purpose and extent of derivatives usage will vary from fund to fund.
Key consideration five – risk analysis and control
It is important to be aware of how managers define risk. Traditionally, bond fund managers used tracking error to measure the risk in their portfolios. Now, however, managers who employ derivatives as defined by the wider Ucits III powers will use value at risk (VaR) to monitor portfolio risk. VaR enables managers to evaluate risk on an absolute basis, rather than a long only basis against an index or benchmark.
And what have we done about it?
When evaluating funds or managers for potential inclusion into our fund of funds and manager of managers ranges, or guided architecture platform, our chief concern is consistency of risk-adjusted returns. We believe a profound understanding of a fund’s strategies and scope of investment should help us build a fair assessment of how future performance will be achieved.
Therefore, the introduction of the IMA’s Strategic Bond sector prompted us to conduct a thorough review of bond funds given the new flexibilities. When we analyse funds, we firstly look at the fund’s objectives, then we examine how the manager is achieving these targets and under what constraints. Therefore, our first, yet critical, step was to explore the diversity in investment approaches in order to assess the funds in the heterogeneous strategic bond sector.
For instance, some funds pursue alpha mainly from credit selection between investment-grade and sub-investment grade corporate bonds, whilst maintaining portfolio duration close to the underlying benchmark. Here, we would expect the strategy to be supported by a strong bottom-up credit selection process and any face to face meeting with the manager would include a detailed discussion of research methods, idea generation and how the diversification of the portfolio is maintained.
Meanwhile, some funds seek to add value from actively managing portfolio duration in addition to credit selection and asset allocation. In this case, the investment process is likely to be a combination of credit selection and implementation of top down macro-economic views.
Regardless of how performance is generated, a thorough understanding of a fund’s risk control process is crucial to us before investing or recommending for consideration to AXA Wealth Strategic Business units. We would want clarification on the manager’s definition of risk (tracking error or VaR, for example) and would also want to know how risk is managed at a number of levels – in other words, idea generation, portfolio construction and ongoing monitoring.
In order to fulfil our investment objectives, we are reliant on our managers consistently meeting their targets, in keeping with their strategies.
Caspar Rock is deputy CIO of Architas Multi-Manager Limited
