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Sector focus: Sterling Strategic Bonds

Such a diverse sector can be a potential minefield for those unfamiliar with its nuances.

TimeBomb

The Sterling Strategic Bond sector has to be one of the Investment Association’s most diverse. With mana-gers’ mandates varying drastically both in terms of what they are trying to achieve and how they go about doing it, the sector can be a potential minefield for those less familiar with its nuances. The difference in performance between the best and worst fund is often extreme. Of course, the plus side of this is such diversity provides wonderful choice for investors.

We have identified four outcomes we believe clients will be trying to achieve from their portfolios: capital preservation, capital accumulation, inflation protection and income. We look to see which of these, if any, managers are looking to fulfil and assess them in that context. This is more useful than trying to compare across a heterogeneous sector.

Capital preservation
Volatility is a strange measure to use in relation to investments as the majority of investors are only concerned with downward legs. However, funds that fall into our capital preservation outcome are not necessarily those where we believe there will never be any volatility but where we believe managers have a strong focus on downside risk, in other words, avoiding any permanent loss of capital.

Fund pick
An example of such a fund would be JP Morgan Strategic Bond. The team targets a return of cash plus 3 per cent over an interest rate cycle and is aware of the risks to capital. This does not mean the fund will never see drawdowns but over the medium to long term, the managers position it so as to minimise the risk of any permanent loss of capital.

Capital accumulation
It may seem counterintuitive to place bond funds in this outcome but, given the strong returns seen in many fixed income markets over the last 25 years, we know it is possible to generate capital growth from bonds. Let’s be clear here: capital growth is usually a secondary concern for fixed income managers and is likely to be modest at best. That said, over the last year, the capital return of the ML Sterling Corporate Bond index has been over 6 per cent – not to be sneezed at.

Fund pick
Artemis High Income is one fund where we feel managers have an eye on capital accumulation. While they expect the majority of returns to be generated through income, a focus on valuations means they have been able to grow capital.
Over the last three years it has enjoyed a price return of over 20 per cent. This is an example of where the diversity of the sector comes into play: the fund can hold up to 20 per cent in equities, clearly an advantage when looking to achieve capital growth.

Inflation protection
Inflation was not at the forefront of people’s minds in 2014. CPI was low, the tumbling oil price had a big impact and, in addition, the price war among many UK retailers, particularly supermarkets, helped to put a lid on it. However, it is worth remembering that, as recently as the summer of 2011, CPI was above 5 per cent and, prior to 2014, had been above the Bank of England’s 2 per cent target for the best part of eight years.

Fund pick
M&G UK Inflation Linked Corporate Bond looks to outperform CPI over three- to five-year periods. While it is likely to show considerably more volatility than the CPI index over shorter time periods, the fund has successfully protected investors from the effects of inflation since launch in 2010.

Income
The main aim of strategic bond funds is to generate income for investors, which has clearly not been the easiest of tasks in recent years. The sector has thus become quite differentiated in terms of the kind of income managers are trying to generate. For example, are they  trying to maintain a consistent level of income? Yield more than a certain part of the asset class? Or perhaps grow distributions over time? Understanding this can tell you a lot about the mentality of the manager and how he is likely to react to different market environments.

Fund pick
An example here  might be Henderson Preference and Bond. While the yield of this vehicle has varied depending on market conditions, the actual value of the dividends has been maintained pretty consistently at between 2.5p and 3.5p per share over its life – quite an achievement given the swings we have seen in fixed income markets over this time.

Victoria Hasler is head of research at Square Mile

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