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Balancing clarity and investment flexibility

A review of the sterling corporate bond fund sector raises the question of how much investment flexibility these funds need, writes Amanda Smith

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The IMA’s consultation with fund management groups about possible changes to its fixed-income sectors has highlighted the need to balance clarity with flexibility in defining the IMA Sterling Corporate Bond sector.

Under current rules, funds in the sector must hold at least 80 per cent in investment-grade corporate bonds and at least 80 per cent in sterling denominated or sterling hedged bonds. The remainder can be invested in to assets such as high-yield bonds or equities, with the same 20 per cent limit applied to foreign currency exposure.

This flexibility can be useful for generating outperformance as managers are not placed in a straitjacket. But the flip side is that investors need to know what they are buying and that funds they have chosen for a specific purpose will not deviate from expectations.

Opinion within the investment industry is divided on whether the current flexibility that sterling corporate bond funds have is sufficient, or whether it needs to be reduced or removed completely.

Kames Capital fixed income investment manager Stephen Snowdon says: “Our view is that with something like the Strategic Bond sector you can rightly expect a broad range of assets. But when it comes to the Sterling Corporate Bond sector the rules should be tight so people are getting what they expect.”

Snowdon does not advocate a blanket ban on other assets and currencies within sterling corporate bond funds because there are circumstances where investing more widely is useful. But he says there should be much tighter restrictions than are currently allowed.

He says: “If you invest in bonds, the companies issuing them can go bust. It is not unusual for their bonds to be converted into equities – that is just a resolution in insolvency and bankruptcy. If no equities were allowed, that would result in forced selling by sterling corporate bond fund managers. The markets would know that, so share prices would collapse to account for the forced sellers. But the current limit seems quite generous given the infrequency of these events and we think 5 per cent is more sensible.”

Snowdon points out that it would be difficult to ban foreign currency exposure because hedging is allowed.

He says: “Our funds buy corporate bonds and hedge back into sterling. We are not allowed to be over-hedged and have to be slightly under hedged, so there will be a residual currency exposure. We think a 5 per cent limit would still provide scope for hedging; even 1 per cent would be enough.”

Other managers would go even further. Rathbone Unit Trust Management head of multi asset investments David Coombs feels the safest way to tighten up the sector is to define it in terms of 100 per cent exposure to sterling corporate bonds.

Coombs says: “The thing with fixed interest is that people buy it and want to know what it is going to do; they do not want anything exciting or special. Allowing up to 20 per cent foreign currency exposure in the Sterling Corporate Bond sector means someone could put the whole 20 per cent in emerging markets – although I suspect that few managers would do that. I’m not aware that many are experts at picking currency and I think doing that tends to encourage managers to take higher risk, not less risk.”

However, L&G Investment Management head of UK retail credit funds Michel Canoy takes a different view.

He says: “Investors should look for funds that are willing and able to access the much larger US dollar and euro markets. This increases the opportunity set, allowing enhanced diversification by sector and issuer.”

In addition to offering greater investment opportunities, allowing greater diversity by allowing exposure to dollar and euro markets also provides these funds with other sources of liquidity, which Canoy sees as vital if there is a liquidity crisis in the UK.

“Some bond managers, including me, are also happy to look beyond the investment-grade market when opportunities in high yield look attractive. That doesn’t always mean taking on huge risks, for example I generally prefer to avoid CCC-rated bonds and financials in my high yield allocation,” says Canoy.

Coombs says that when he buys funds for his multi-asset portfolios, he does not want any nasty surprises. “When I buy a fund I am looking to allocate money to experts and maximise returns; I don’t want them going ‘off piste’. The managers should be justifying their fees by adding alpha in their own asset class.If you allow managers to invest outside their asset class or area of expertise, it’s difficult to track the risk.”

Peter Lowman, chief investment officer at wealth management boutique Investment Quorum says: “If a manager is allowed exposure to currency risk or equity within the portfolio, this needs to be considered in terms of how much more risk that might involve if a fund is bought for specific clients.”

Snowden says some fund groups have been active in equity and foreign currency exposure and takes issue with this only if investors are unaware that this is driving performance. He expects these firms to resist any changes to the sector limits in case there is a negative impact on performance.

Coombs says that reducing current limits will narrow the opportunity set for managers but points out that those who bought unrated bonds and other ‘sexy’ investments in 2008 got in to trouble performance-wise.

But adviser firm IPFM director Luke Gibbon believes factors such as interest rates will have more of an impact on fund performance than any potential changes to sector limits. He says: “I suppose reducing the limits would affect some funds in the short term but I do not think that is as relevant to performance as what is going to happen in the markets.”

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