The strategic bond sector has to be one of the most diverse as defined by the Investment Association. With managers' mandates varying drastically, both in terms of what they are trying to achieve and how they go about doing it, the sector can be a potential minefield for those who are less familiar with its nuances, with the difference in performance between the best and the worst fund often extreme. Of course, the plus side of this is that such diversity provides wonderful choice for investors, with a range of potential outcomes for clients.
At Square Mile we have identified 4 outcomes which we believe clients may be trying to achieve from their portfolios: capital preservation, capital accumulation, inflation protection and income. We then use these outcomes to frame our thinking when looking at investments. Clearly this can be quite useful when looking at an area as diverse as the strategic bond sector. Essentially we look to see which, if any, of these outcomes managers are looking to fulfil (recognising that they may fulfil more than one outcome) and then assess them in that context. We find this a more useful way of looking at funds than trying to compare across a heterogeneous sector where any two funds may be looking to do entirely different things. This is particularly true during more volatile market conditions, when understanding exactly what a fund is trying to achieve, and within what parameters, is vital in understanding the noise.
1. Capital preservation
Over the last 10 years we have seen at least 3 very meaningful spikes in volatility, along with several smaller spikes which no doubt felt meaningful enough at the time. Of course, volatility is in some ways a strange measure to use in relation to investments, as the majority of investors are only actually concerned with the downward legs. This is where our first outcome comes into its own. Funds which fall into our capital preservation outcome are not necessarily those where we believe there will never be any volatility, but rather where we believe that the managers have a strong focus on downside risk, or, in other words, on avoiding any permanent loss of capital.
An example of such a fund would be the JP Morgan Strategic Bond fund. The management team target a return of cash plus 3% over an interest rate cycle, and are very aware of the risks to capital. This does not mean that the fund will never see drawdowns (for example there was a c. 4.5% drawdown in May/June 2013, largely due to the holdings in emerging market debt, which suffered during the period), but that over the medium to long term the managers position the fund so as to minimise the risk of any permanent loss of capital.
2. Capital accumulation
It may seem a little counterintuitive to place bond funds in the capital accumulation outcome, but given the strong returns seen in many fixed income markets in the last 25 years or so, we know it is entirely possible to generate capital growth from bonds. Let's be clear here - capital growth is usually a secondary concern for fixed income managers, and, a few notable periods excepted, is likely to be modest at best. This said, over the last year the capital return of the ML Sterling Corporate Bond index has been over 6% - not to be sneezed at.
The Artemis High Income fund is one where we feel that managers have an eye on capital accumulation. Whilst they expect the majority of returns to be generated through income, a focus on valuations means that, over the long term, the managers have been able to grow capital. Over the last 3 years the fund has enjoyed a price return of over 20%. This is an example of where the diversity of the sector comes into play; this fund can hold up to 20% of its assets in equities, clearly an advantage when looking to grow capital.
3. Inflation protection
It is fair to say that inflation was not at the forefront of people's minds in 2014. The Consumer Price Index (CPI) was low, and certainly below the Bank of England's 2% target; the tumbling oil price had a big impact, and in addition, the price war amongst many UK retailers, particularly the supermarkets, helped to put a lid on inflation. However it is worth remembering that as recently as the summer of 2011 CPI was above 5%, and that prior to 2014, inflation had been above the Bank of England's 2% target for the best part of the previous 8 years.
The M&G UK Inflation Linked Corporate Bond fund looks to outperform CPI over 3-5 year periods. Whilst it is likely to show considerably more volatility than the CPI index over shorter time periods, the fund has successfully protected investors from the effects of inflation since launch.
The bulk of strategic bond funds will aim, to a greater or lesser extent, to generate income for investors. Clearly this has not been the easiest of tasks in recent years! The sector has thus become quite differentiated in terms of the kind of income which managers are trying to generate. For example, are the managers trying to maintain a consistent level of income? Yield more than a certain part of the asset class (eg investment grade corporate bonds)? Or perhaps grow distributions over time? Understanding this can tell you a lot about the mentality of the manager and how he is likely to react to different market environments.
An example of this might be the Henderson Preference and Bond fund. Whilst the yield of this vehicle has varied depending on market conditions, the actual value of the dividends has been maintained pretty consistently at between 2.5p and 3.5p per share over the life of the funds. Quite an achievement given the swings we have seen in fixed income markets over this time.
By Victoria Hasler, Head of Research
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