Last year was an eventful one, with surprising political results adding to continued central bank actions driving volatility in credit markets. The resulting dislocations did offer some investment opportunities, however.
Funds in the Investment Association Sterling Strategic Bond sector that exhibit biases to specific parts of the credit market were able to capitalise on these trends, leading the overall sector to deliver returns close to 7 per cent over 2016. So far in 2017 it has delivered just over 1.5 per cent.
Last year started with high yield continuing its sell-off from late 2015, driven primarily by the weakness in energy related credits, along with the financial sector taking a tumble due to concerns around the impact of negative interest rates on banks’ profitability.
But both sectors staged a turnaround from mid-February. Global high yield ended the year on a strong note, with CCC-rated bonds one of the best-performing areas of the market. This helped funds with a bias towards lower quality bonds see the year out strongly, even though some were the worst performers in February.
Duration was another driver during the first half and extending into the third quarter, as core government bond yields broadly declined during that period. The European Central Bank’s announcement of its corporate sector purchasing programme in March buoyed European investment grade bonds.
Then political risk in the form of the Brexit referendum took the front seat in May and June. The surprising Leave vote led to a rally in rates. Ten-year gilt yields dropped from 1.37 per cent on the day of the vote to a low of 0.52 per cent in early August, as the Bank of England cut rates to 0.25 per cent and expanded its asset purchase programme to include up to £10bn of UK corporate bonds.
The Bank of Japan shifting its policy to focus on yield curve control rather than just expanding money supply was also seen as a positive, especially for banks. These moves aided returns for funds holding higher quality assets – both sovereign and corporate bonds – as well as those holding longer-dated bonds.
The US elections threw in another surprise. Donald Trump’s victory led to an immediate spike in US treasury and other core government bond yields. It also provided a boost to a budding reflation theme underpinned by improving economic data in the US and Europe, as well as from a broader shift from monetary to fiscal expansionary polices.
The US Federal Reserve hiking rates by 0.25 per cent and the ECB announcing a reduction in its asset purchase programme by €20bn from April 2017 also added to bond investor concerns. Higher inflation and growth in the US led the Fed to increase interest rates again in March, leaving it with enough scope for further tightening later in the year. In light of this, a number of managers remain cautious on the interest rate front, though they see value in credit.
A factor driving the latter is that higher growth expectations typically lead to a steepening of the yield curve, which is beneficial for banks, especially
in the US where they are further down in their deleveraging
efforts and could benefit from deregulation introduced by the
Uncertainties around central bank policies, fiscal policy from the Trump administration and political risks from elections in France and Germany are likely to create pockets of value across the global bond markets.
Strategic bond funds that can dynamically exploit these uncertainties can be valuable. That said, it is extremely important to understand a fund’s objective and its biases to judge its suitability
Henderson Strategic Bond has been managed by John Pattullo since its launch in 1999. Jenna Barnard became co-manager in 2006. A key driver is the managers’ asset allocation process, influenced by their assessment of macro and market factors, which are then married with stock-specific analysis. The managers have historically shown a bias towards US and European names, with a 20-80 per cent high yield exposure over the last 10 years. Derivatives are also used to give more flexibility to express views on duration, broad credit markets and individual credits. The fund holds a Morningstar analyst rating of silver.
Jupiter Strategic Bond has been managed by Ariel Bezalel since its inception in mid-2008. He combines his top-down macro views with bottom-up security selection from the credit analyst team. The fund’s unrestricted “go anywhere” approach, with the flexibility to invest in corporate and sovereign issuers globally and straddling the credit ratings spectrum, has led to strong risk-adjusted returns since launch. It holds a Morningstar analyst rating of bronze.
M&G Optimal Income has been managed by Richard Woolnough since its inception in late 2006. His expertise in macro analysis and ability to allocate across the fixed income universe underpin its unconstrained approach. The fund can hold up to (with no minimum) 100 per cent in investment grade, high yield and government bonds,and up to 20 per cent in equities (held only when viewed as especially cheap). Duration is also actively managed, often using a derivatives overlay. The fund holds a Morningstar analyst rating of silver.
Ashis Dash is associate director for fixed income strategies at Morningstar