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Strength in diversity

James Smith reports that the flexible and disparate nature of the global bond sector has brought strong returns over recent years

Global bond is a diverse sector where like-for-like comparisons are difficult as it comprises non-sterling funds as well as those investing across the world.

But the upside of this flexibility has seen many funds benefit in their performance over the recent period. For three years to the end of July, the average global bond fund is up just over 40 per cent, compared with 21.5 per cent from sterling corporate bond and 29.2 per cent from sterling high yield.

Strong returns have caused a surge in popularity and the sector enjoyed its best-ever quarter of net sales in the third quarter last year as investors sought more diverse fixedincome exposure.

Top of the peer group over three and five years is the GLG global corporate bond fund.

Previously known as SG international bond, the fund changed name and mandate following the GLG acquisition in 2009 and came under current manager Christophe Akel.

The fund outperformed by more than 600 basis points over 2010 with the same volatility as its benchmark, and Akel cites his overweight in subordinated financial debt as key.

Elsewhere, the portfolio’s skew towards the lower end of the investment-grade area – BBB-rated debt – has also added significant value.

Akel says: “On financials, the regulatory regime is changing with measures such as Basel III, which should be supportive of subordinated debt.

“More generally, we are also concerned about a pick-up in the merger & acquisition cycle and feel that focusing on BBB debt serves as a cushion against this.

These companies are keen to maintain investment-grade status and are therefore continuing to manage their capital structure cautiously, which is positive for bondholders.”

According to Akel, the major bond theme over much of 2011 has been long high-yield credit but he says lower-quality investment grade is offering better value on a risk-adjusted basis.

After a long period of complacency about low interest rates, he now believes the market has overreacted in the opposite direction, pricing in too much rate risk, especially in the UK.

He says: “We are entering a long period of rising base rates but they will not go up in a straight line and we feel the market has rapidly moved to price in too many hikes. Inflation is the other major concern and we tend to invest in companies that can pass through price rises to consumers, focusing on so-called price-makers rather than price-takers.”

In terms of geographical exposure, the fund is substantially overweight the UK, with its bank bonds cheap compared with European debt and the team happy with current deficit-reducing austerity measures.

Akel says: “We will continue with our policy of tail-hedging the fund and managing exposure to interest rates.We still believe there is more pain to come from peripheral European countries and will maintain low exposure to the region as a result. In the medium term, we remain constructive on investment grade with healthy inflows and still negative net issuance.”

Second in the peer group over three years is Janus US high yield, with co-manager Gibson Smith focusing on companies with solid free cashflow and improving balance sheets.

This meant the portfolio outperformed in 2008 and lagged the powerful rally in 2009 before registering top-quartile numbers again last year.

Smith says credit selection has been a key driver of the performance, with holdings in BB and CCC-rated securities particularly positive.

He says: “Looking at our sector exposure, we have benefited from our automotive and gaming holdings while our non-captive diversified financials and lack of exposure to life insurers held back relative returns.”

After strong performance in 2010, Smith feels the easiest opportunities have passed and it may be time to become defensive in certain sectors.

He says: “We believe that late-cycle names, such as natural gas producers, will benefit from a strong economy in the future, with increased industrial demand for their products. Some of the early-cycle names, such as steel and chemical producers, have traded at very tight levels, having benefited from pricing power earlier in the recovery. We see valuations in these sectors to be relatively high and believe their pricing power is likely to wane.”

As might be expected in light of prevailing macro themes over recent years, several emerging market debt funds are among the sector’s top performers, with the asset class enjoying a major popularity surge last year.

The £1.7bn Investec emerging markets local currency debt fund is the best performer in this particular sub-group, with manager Peter Eerdmans high lighting his contrarian stance. He took profits on several of its long ideas early in 2010, for example moving exposure to Turkey, Indonesia and Hungary to neutral, having benefited from a rally in markets running through 2009, as he recognised emerging debt was approaching the end of a strong run.

After this strong run, Eerdmans saw 2010 as back to a relative value environment, taking positions such as overweight Chilean local bonds versus under-weights in Mexico, for example.

Overall, Eerdmans remains relatively optimistic on growth in emerging markets and therefore credit quality across its fixed income.

He says: “Central banks will continue to keep their eye on inflation and with real interest rates still in negative territory in many emerging markets, there is still significant upside pressure on rates.

“Trade balances continue to improve, with absolute levels of exports continuing to trump imports. Domestic demand remains robust and with headline inflation continuing to moderate on the back of moderating food prices, we feel this provides a favourable backdrop for growth, despite the ongoing headwinds from the developed world.”

More recent moves on the portfolio have included an increase in the underweight duration position, as the team continues to believe the generally negative outlook on growth is overdone.

Eerdmans says: “Bonds have been range-bound and we expect this trend to continue as markets oscillate between fears of weaker global growth versus higher inflation. Fundamentally, we believe growth is neither going to collapse nor going to cause inflation to spiral out of control.”

Recent sales in Peru and Mexico mean the fund is now underweight or neutral in all regions except Africa, here Eerdmans maintains an overweight position in South Africa.

He says: “We think policymakers will be generally more comfortable letting their currencies appreciate to temper inflation, given the positive trade balances, so remain overweight.

“The continued upward pressure on interest rates remains accommodative to currency appreciation and after the general sell off in emerging market currencies in May and modest returns in June, we believe flows will become positive again.”

The Templeton global total return bond fund is another top performer, with manager Michael Hasenstab highlighting his strategy of cushioning the portfolio against rising yields.

His strategy has been to use an average duration of less than half that of the benchmark, have no exposure to US treasuries or Japanese government bonds and minimal positions in eurozone government bonds

Hasenstab says: “Additionally, we believe there can be opportunities to capitalise on rising yields in the US by positioning long the dollar against the Japanese yen.

“We continue to favour short-maturity bonds in countries such as Australia, Israel and South Korea where yields between 3 per cent and 5 per cent are available on bonds with less than two years of duration and strong creditworthiness.

“Although emerging market sovereign bond spreads have narrowed from crisis-driven levels, we still find value in the sector as the slower-growth environment has created financing needs in countries with solid credit fundamentals that have not issued in several years.”


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