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Top tactics: strategic bond funds start to shine

With rates remaining low and China struggling,strategic bond funds have been through a difficult few months but value is starting to emerge

Top tactics: strategic bond funds start to shine

The strategic bond sector covers a wide variety of strategies. Most funds hold a mix of government, corporate and high yield bonds. Some funds are more like absolute return vehicles that can go both long and short, and others are even happy to hold some equities.

The typical strategic bond fund has had low duration over the past few years to protect against rising interest rates. Often they have had reasonable exposure to riskier high yield bonds over investment grade. These strategies have hindered performance as rate rises keep being deferred and high yield suffered a sell-off as fears of a Chinese slowdown hit riskier assets.

After the recent underperformance of corporate bonds relative to gilts, value may be starting to emerge.

In February this year the yield on the IBOXX Sterling Corporate Bond All Maturities index of investment grade bonds was 3%. Now, it is 4%, a pretty big move. Funds with a greater allocation to riskier high yield bonds can often yield more than 5%.

While this is lower than you may have seen historically, relative to a 10-year gilt at 2%, base rate of 0.5%, and inflation at zero, this looks pretty attractive.

Strategic bond funds are neck and neck with gilt funds over five years

Source: Lipper

STRATEGIC BONDS

Growth 3/5

Room for growth

With 10-year yields at 2% there is little scope for gilts to grow. There might be short-term gains during ‘risk off’ periods but in the longer term I would expect yields to rise meaning capital falls.

However, a typical strategic bond fund yielding around 5% is an entirely different matter. With such a wide spread over gilts there is plenty of scope for this to narrow, meaning some capital growth.

Risk 2/5

Low duration

Gilts have a high duration, so are sensitive to interest rate movements. A 10-year gilt has duration of around nine years. Many strategic bond funds have much lower duration, perhaps five years or less, and so interest rate risk is relatively low in the event rates go up.

Corporate and high-yield bonds carry credit risk but low rates and a stable economy should help keep default rates down.

Value 4/5

Relatively good

Value in bonds is very much in corporates and high yield. The spread of corporate bonds over gilts is 2%, well above the typical 1% spread that was found before the financial crisis. They yield 3.5% above cash and with inflation at zero your real yield is high. High yield looks even better value.

However, while relative value is excellent, in absolute terms yields are well below long-term averages.

Quality 2/5

CoCo conundrum

Quality is variable, especially credit quality. Some bonds have strong covenants and are secured directly on a company’s assets. However, so-called covenant-lite bonds are on the increase, as the search for yield leads some investors to focus less on quality.

This is especially prevalent in the financial sector, where contingent convertible bonds (CoCos), which convert to equity if bank capital falls below a certain threshold, are becoming common.

Momentum 2/5

A poor run

There is little momentum in the sector after a poor run for strategic bond funds, at a time when gilts performed well. There may be early signs of this changing with gilt yields increasing and strategic bond performance improving during October.

We have seen a long-term trend of falling yields over recent decades, however this cannot continue and I expect less consistent returns over the next 10 years.

VERDICT

I have not been keen on fixed interest in general for some time, preferring property, but with yields increasing, value has emerged in corporate bonds. I am happy to take a reasonable level of credit risk given the potential for higher returns and low default rates.

With interest rates unlikely to increase in the next 12 months, the risk/return trade-off for strategic bond funds with some high yield exposure looks favourable.

HOW TO PLAY IT

Even though rates may stay low, we prefer shorter duration. Around five years seems to be a sweet spot: long enough to be able to pick up a decent yield but short enough for realistic rate expectations to be built into the price.

I like the TwentyFour Dynamic Bond fund and the Jupiter Strategic Bond fund, both of which yield around 5%. We also use the Irish Ucits Royal London Extra Yield Bond fund, which yields more than 6%.

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