The members of the IA Sterling Strategic Bond sector often have very little in common, but one thing the most popular members of this sector in the Asset Allocator database have shared in recent years has been a struggle for performance.
In theory, managers of strategic bond funds have a similar degree of autonomy when selecting the assets they think will generate returns for investors: these funds are not even required to have a portfolio made up entirely of bonds.
The IA definition of the sterling strategic bond sector stipulates that constituents must have at least 80 per cent of their assets in sterling denominated fixed interest securities.
It also notes that at any point in time the asset allocation of these funds could theoretically place them in other fixed interest categories.
Fund managers themselves are no less vague when discussing their objectives. The Jupiter Strategic Bond Fund, the most popular in our database, promises to deliver for investors “by diversifying across different types of debt and across the credit spectrum”.
But this freedom has not resulted in some of the biggest name funds delivering stellar returns lately.
For example the above-mentioned Jupiter fund, run by Ariel Bezalel, has lost 5 per cent over the past three years and has underperformed its sector in three of the past five calendar years.
Nomura Global Dynamic Bond, which is now tied with Jupiter as the most popular strat bond fund, has lost 8 per cent over the past three years.
Chris Metcalfe, chief investment manager at Iboss, owns M&G Optimal Income, JP Morgan Global Bond Opportunities and L&G Strategic Bond.
He says the flexible mandates of strategic bond funds can be a benefit or a drawback depending on the way assets are allocated.
“The manager has maximum latitude to use duration, credit quality and, in some cases, equities to add alpha for their investors,” he says. They can also utilise currency and derivatives to add value or control risk.
“The flip-side is that all these potential benefits can destroy value if the manager makes the wrong calls,” Metcalfe adds.
He says the thing which currently marked out a strong strategic bond fund was how its manager performed since Federal Reserve chair Jay Powell admitted inflation was not transitory in November 2021.
Metcalfe says: “From our perspective, the best-performing strategic bond managers didn’t entirely buy into this narrative about lower forever interest rates.”
As you might expect given its broad mandate, the portfolios of strategic bond funds vary widely. At January 31, just over 41 per cent of Janus Henderson’s strategic bond assets were government issued, while a further 24 per cent were investment-grade non-financial corporate bonds. Only 4.3 per cent of assets took the form of cash and derivatives.
Jupiter’s Strategic Bond Fund, on the other hand, favours corporate debt and bond futures over other fixed income securities.
This is also the case with Baillie Gifford’s Strategic Bond fund, which has 43 per cent of assets in the industrials sector and 38 per cent in financials. Its top holdings are banking giant NatWest and the Spanish telecoms group Telefónica.
Attitudes towards duration – a measurement of how sensitive a bond is to interest-rate changes – also differ from manager to manager.
In fact, our number crunching shows there is a rough correlation between shorter duration and better performance over the past three years relative to the sector.
This also might explain why the popularity of some of the longer duration strategic bond funds has softened lately among the allocators in our database.
“Some [managers] like to take big-duration positions, which can lead to big ups and downsides,” explains Robert Fullerton of Hawksmoor. “On the other hand, some prefer to stay close to the benchmark on duration and try to add alpha through their sector allocations and bottom-up positions.”
Iain Stealey, manager of the JPM Global Bond Opportunities fund and international chief investment officer for global fixed income, currency and commodities, runs a fund with a shorter duration than some of its peers in the strategic bond fund sector - with the fund's duration currently at four years.
He said: "This represents a broadly neutral position in the context of our strategy’s history. Strategically, it makes sense to own some duration now given the overall downward inflation trend, the likely end of central bank rate hikes and the fact that bonds are offering income and diversification benefits.
"But markets have largely priced the prospect of rate cuts in the coming months, leaving core government bonds around fair value. We are conscious of the risk that the market can get ahead of itself and price too much, as seen in recent weeks when central banks had to push back on market expectations given stronger economic data and hotter-than-expected inflation.
"So for now, while our base case remains a soft landing, we are wary of over-extending duration."
Simon Evan-Cook, manager of the Downing Fox portfolios, who holds no strategic bond funds, says: "The trouble with strategic bond funds is that they must compete with other strategic bond funds, so they can't afford to thumb-twiddle in the four out of five years that equities aren't crashing.
"The pressure is instead to join in with the rally, which then heightens the risk of them not protecting when the bad year rolls around."
Ultimately, asset allocators interested in adding a strategic bond fund to their own portfolios must ensure they share its manager's view of the world.
If you are wary of high-yield bonds, for instance, it is wise to ensure a fund does not hold too much junk-rated debt. If you are sceptical that rates are going to fall this year, short-duration bond exposure should be at the top of your priority list.
It is also worth evaluating how often and how well a manager uses derivatives to make a profit when bond values are falling and yields are rising, as they have at various points in the past few years.
Though derivatives might get a mention on many fund factsheets, some investors think that risks were not adequately anticipated and hedged.
“Reality proved that the vast majority of managers underestimated the size of the rate hikes, carried too much interest rate risk, failed to provide protection and made very large losses by historic standards,” notes James Crocker, a partner at investment management group Albert E Sharpe.
“Many investors misunderstood the word ‘strategic’ to mean prudent or guarded”.
This is not to suggest that strategic bond funds are inherently perilous. Crocker reports that Albert E Sharpe’s balanced portfolios currently have 14 per cent of assets in these funds, which is higher than some of their peers.
“This is because we have high conviction in the ability of the managers chosen and feel that at this point in the cycle there will be a lot of opportunities,” he explains.
If anything, strategic bond funds prove that the fixed income world is not the staid and steady world it is sometimes made out to be.
Jennifer Johnson is deputy funds editor on sister title Investors' Chronicle
