What has gone wrong for so many managers over the past 12 months?
Only five out of 80 (6.25 per cent) strategic bond managers achieved positive performance in 2018, with the sector averaging a return of -2.49 per cent.
The list of achievers includes Pimco GIS Income, Allianz Strategic Bond and three Royal London AM funds – Sterling Extra Yield, Global Bond Opportunities and Short Duration Credit. The RLAM credit desk made up of Paola Binns and Eric Holt deserves praise, as does Allianz’s Mike Riddell for his use of a global benchmark (sterling hedged), which pushed him to invest largely in government bonds last year.
So why did managers fare so poorly last year? Strategic bond managers have the flexibility to invest across bond markets but cannot rely on currency bets. There were very few places to hide in 2018’s bond markets.
Almost a third of the 100 fixed-income asset classes tracked by M&G delivered positive returns last year, led by traditional safe havens (US treasuries, European government bonds and Japan’s sovereign debt).
Safe havens did in 2018 what they usually do: deliver positive returns when it rains. While corporate debt markets and developing nations suffered from higher interest rates, a stronger dollar and ongoing trade wars, along with sluggish global growth, safe havens remained solid. As a result, asset allocation decisions were very hard to call last year, so strategic bond managers cannot be blamed for not delivering safe-haven-like returns.
However, we should be concerned by the scale of losses. The Investment Association Sterling Strategic Bond sector reached a maximum drawdown of -2.70 per cent in November. Since the financial crisis in 2008, the only drawdown figures which were worse were posted in September 2011 (eurozone debt crisis), June 2013 (“tapering tantrum”) and February 2016 (Chinese economic slowdown). Thirty strategic bond funds lost more than 3 per cent last year, with the worst performers Legg Mason Western Asset Macro Opportunities Bond, GAM Star Credit Opportunities and L&G Dynamic. The depth of losses was significant as managers failed to identify a change in market environment.
Many of these funds did not change their portfolio composition in 2018, while their mandate required flexibility. Since 2008, stereotypically, strategic bond fund managers have positioned their portfolios with low duration and a high amount of credit risk. This has worked well, with the sector recording a positive annualised return of 7.20 per cent from 2008 to 2017. Investment-grade bonds with a maturity of between five and seven years offered better risk-adjusted returns, so managers did not have to take higher interest rate risks. This short-duration positioning failed to work last year, especially in the fourth quarter.
The key issue in 2018 was not duration positioning, but the amount of credit risk strategic bond managers took. The credit quality of the investment-grade market has deteriorated over recent years, as allocation to BBB-rated bonds has increased. Many active fund managers followed the herd by increasing their credit risk significantly, through lower credit rating and risky industry allocations. With little sign of an economic slowdown, fund managers expected cyclical companies to enjoy stronger earnings and improve their capacity to repay debt. They had piled a huge amount of credit risk in high beta sectors such as financials, oil and gas, and high yields.
These bets failed as oil prices collapsed, European banks got hit by the Italian election and Germany’s largest lender, Deutsche Bank, ran into trouble. These industry-specific stories hit at the worst time, as investors decided to reassess valuations for investment-grade bonds. The difference in spreads between government bonds and corporate bonds was simply too low, and that spread widened when the probability of a global economic slowdown increased. The high level of risk best explains why strategic bond managers failed to protect from the downside last year.
Looking back, it is disappointing to observe the 2018 performance of the IA Strategic Bond sector. It was a challenging year and bond managers cannot always be 100 per cent right with their asset allocation bets. Nevertheless, we are more disappointed by their lack of reactivity. Across the board, the positioning of portfolios has remained identical, as if last year never happened. The drivers of performance remain the same: long credit and short duration. If 2019 turns out to be another 2016, then congratulations to them – although you cannot give credit to portfolio managers for their passivity.