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Plan B for bonds

How are bond funds reacting to the equity bull run?

As equity markets have experienced one of their best bull runs, bonds tend to have been regarded as equities’ “ugly sister”, with investors leaving in droves.

Fixed income used to be a stalwart in many portfolios, producing returns and, in some cases, providing downside protection. But in today’s environment of historically low interest rates, quantitative easing and rising equity markets, bonds have been left in the dust. 

JP Morgan fund manager Iain Stealey, who co-manages the £600m JPM Strategic Bond fund, recognises the difficult environment currently facing bond fund managers. He says: “We have had a challenging year. We are seeing a lot of people needing to own fixed income but moving away from traditional strategies.

“A lot of people are concerned about interest rates so they are wanting more flexibility.”

The industry response to these challenges has been driven by innovation, with a spate of bond fund launches with new debt and duration structures, including short-dated, negative duration and floating rate note bond funds.

Blackrock fund manager Ian Winship, who manages the £88m BlackRock Absolute Return Bond fund, welcomes this. He says: “In the past, you have have fixed income fund A and fixed income fund B and if the market went up one of those funds would give you a return.

“But investors cannot afford this anymore and you have to be a bit smarter. Something must also be said for our clients in the market who are looking for a wider range of products.”

Yet Kames Capital fund manager Stephen Snowden, who co-manages the £680 Kames Investment Grade Bond fund, is slightly more cynical about the direction of travel the newer bond funds are taking. Snowden says: “Theoretically, these sorts of funds are wonderful as you have to reinvent yourself. But while these funds are great concepts, they generate hardly any yield as there is little risk.”

As for existing funds, Henderson Global Investors head of retail fixed income John Pattullo, who co-manages the £1bn Henderson Strategic Bond fund, says: “This year was always going to be a toughie. We have been exposed to credit risk and high yield – investment grade has not done a lot for us this year. It is all about being credit sensitive, not interest rate sensitive.

“We have stayed away from emerging market debt, it is overvalued and destined for a fall. Emerging market debt is a potential firecracker. If the US raises its interest rates, then all the money will come out of these funds and go somewhere else, which will be a problem.”

Royal London Asset Management senior bond fund manager Paola Binns, who manages the £112m Royal London Duration Hedged Credit fund, has adopted a hedging strategy to defend against interest rate risk.

Binns says: “With this fund, I take a pool of corporate bonds and hedge interest rate exposure with interest rate swaps. So you still get exposure to pricing on corporate bonds but exposure to interest rate risk managed.”

Winship has decided to stick with traditional bonds and is setting duration based on US forward guidance. Winship says: “In terms of duration, my strategy is quite simply to listen to the Federal Reserve as it did not seem comfortable when the market rallied.

“If I am right about central banks, then I am right about buying corporate credit. I am looking to increase my allocation to credit, gilts and emerging markets. It will help us add more risk to the portfolio.”

In a true display of ‘if you can’t beat ’em, join ’em’, some bond fund managers have decided the way forward is simply to invest in equities. 

According to the Investment Management Association, the Global Bond, £ High Yield, £ Strategic Bond and £ Corporate Bond sectors all require a minimum 80 per cent weighting of assets in fixed income securities, allowing for a 20 per cent non-fixed income asset allocation. The UK Index Linked Gilts and UK Gilts sectors allow for 5 per cent non-fixed income asset allocation. 

But some bond fund managers do not approve of this approach.

Stealey says: “Including equities is pushing the boundaries. We like to tell our clients we have proper bond funds and that there are opportunities out there for fixed income.”

Pattullo does not allow for equities to be included within his bond funds. Pattullo says: “We do not do it because our clients want us to be invested in fixed income. The IMA is a little bit loose on what can go in and out of a bond fund.

“Personally, I do not think that is particularly helpful. It can be frustrating when extra returns are being gained from asset classes that are not bonds.”

Provisio Chartered Financial Planners managing director Andrew Whiteley says certain types of bonds do not have the same allure as they used to, but he still recognises the worth of fixed income. Whiteley, who prefers corporate bonds over gilts, says: “We still believe clients in balanced portfolios should have bonds as they are still giving a better yield than cash.

“Also, if interest rates do rise then it will be a gradual process and will not happen overnight. If we do need to shift out allocation in that eventuality then we have a fairly good heads up with central bank forward guidance.”

Snowden adds: “If interest rates rise too quickly and by too much and trip up economic growth then quantitative easing will be kicked back in. If you want to bet against this asset class, you are betting against the biggest investors in town.”


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