A recent trend in fixedincome investment is the rise of strategic bond funds, which now top the fixed sales charts. However, these funds are not a new idea – we launched ours in 2003, so why are they so popular?
They are significantly more flexible than other fixed funds, in particular, they are not forced to hold minimum asset-class allocations such as Government bonds. They can also have a genuinely global investment remit, although most hedge the majority of their currency exposure back to sterling. Investors benefit from greater diversification while avoiding currency risk.
As uncertain economic and political outlooks keep investors nervous, many find it attractive to delegate fixed income strategy to professional managers who are close to the markets and able to use flexibility to seek returns and control risks.
The two big questions now facing fixed-income managers are how much credit risk to take and what to do about interest rate risk?
Corporate bonds rallied significantly last year. A skew to financial or high yield bonds has allowed fund managers to post greater total returns than market averages.
After such a strong rally it is reasonable to question whether there is value left in credit. We believe there is more to play for but, since August 2009, we have taken a disciplined approach to reducing our credit overweight as spreads tighten.
However, you need to get your sector and stock selection right. We have been saying for a while that, unlike 2009, credit sector and stock selection will be as important as asset allocation this year.
Most non-financial sectors – utilities, telecoms and industrials – are trading close to 2007 levels and are about as expensive as we have ever seen. There is still value in the financial and collateralised sectors but you need to do your research as there is not value in every company or bond.
There are opportunities in US companies’ sterling or euro-denominated bonds and UK companies’ dollar or euro-denominated bonds. Many parochial local investors shy away from foreign companies they do not know much about, which creates opportunities.
Regarding interest rate risk, there is a consensus that Government bond yields will rise as economies recover. However, much of this is already priced in – Government debt performed poorly for most of 2009.
The fund is short duration (interest rate exposure) in anticipation that the recent sell-off has further to go but the majority of investors seem to have the same position.
In the UK, for example, this month’s unexpectedly high inflation numbers did not precipitate the logical sell-off in gilts, with yields barely moving. That suggests most of the market is short – and if no one has bonds to sell, prices are unlikely to fall by much.
We believe in the short interest rate position but expect the reward may be released slowly as yields rise gradually rather than soar.
This is where the flexibility of strategic funds is useful. A short position in UK assets may be a longer-term strategy but there are other opportunities to profit from the recovery.
The world’s economies are recovering at different rates around the world. Canada and Australia benefited from going into the crisis with less debt than other major economies and have recovered faster due to demand for their natural resources. Meanwhile, Europe’s recovery may be hampered by the weakness of Greece, Spain, Portugal et al.
Earlier this year, we were short duration in Canada paired against a long German position. Both legs of this trade made money as the economic stories evolved. Furthermore, our purchase of Australian inflation-linked bonds as the recovery story gathered pace has paid off.
Of course, nothing stays the same for long. There will be economic surprises in Australia, Canada, Europe and the UK, and good and bad news for companies. Markets will continue to overact, which creates opportunities.
This flexibility makes strategic bond funds alluring. Indeed, one wonders whether pure Government bond and corporate bonds funds will become marginalised and only used by larger, professional investors.
Kevin Telfer is a fixed-income product specialist at Aegon Asset Management