Strategic bond funds have become the new 'must have' investment according to Morningstar's latest fund flow data. These flexible products are designed to be a 'one stop shop' for investors wishing to gain access to a diversified portfolio of bonds managed by a specialist investor. This populist approach has clearly caught the imagination of investors with more than £8 billion being invested in these funds over the last year. In contrast, almost every other bond sector has suffered outflows as investors have become concerned about the near term outlook for interest rates. The popularity of strategic bond funds during a period of more difficult bond market conditions suggests that investors are increasingly losing confidence in their own ability to select the most attractive areas of the bond markets and seeking to hand over the allocation of their bond exposure to an expert.
Although strategic bond funds may appear to offer a simple solution, selecting the right one is far from easy. The strategic bond sector is full of offerings with disparate strategies. While credit exposure is a key differentiator, funds also vary in their approaches to market maturity, interest-rate risk and derivative use, among other factors.
Each of those distinctions carries with it implications for funds' risk/reward profiles, so a strategic offering that's right for a young investor seeking higher-risk bond exposure may not be right for a retiree seeking a stable level of income through the market cycle.
Therefore before adding strategic-bond exposure to your portfolio, ask yourself the following questions.
Question 1: What's my existing bond exposure?
Before adding a strategic bond exposure to your portfolio, it's worthwhile to check how much exposure you have to bonds in other parts of your portfolio. Most mixed funds and managed portfolios will have an allocation to bonds that will overlap with the exposure of a strategic fund. By holding a strategic fund alongside a mixed portfolio you may actually be doubling up on specific risks rather than diversifying your portfolio. Morningstar’s portfolio X-ray tool can help you with this analysis. By comparing the bond exposure of your portfolio before and after the addition of a strategic bond fund you can see which risks are increased and which are diluted. Morningstar fund reports’ credit quality box can also show you the key exposures of the strategic bond fund you are analysing.
Question 2: What am I hoping to achieve by adding a strategic fund?
Any time you're adding an investment to your portfolio, it pays to step back and consider what goals you're trying to accomplish with the addition.
Are you adding a strategic bond fund to serve as an aggressive kicker to an otherwise staid fixed-income portfolio, as would be the case with a fund dominated by high yield exposure? Are you comfortable with a volatility level that falls somewhere between that of an equity fund and a gilt fund? If so, it's fine to focus your energies on more aggressively positioned strategic bonds funds. An example of this type of fund would be the Morningstar Silver-rated Artemis Strategic Bond fund. Returns from this type of fund have been generally excellent over the last few years, but note that they'll tend to be much more highly correlated with equities.
Alternatively, perhaps you're considering a strategic bond fund to diversify your fixed income exposure across a broad swathe of bond markets but you're not looking for a big pick-up in returns relative to what you're already getting from your high-quality fixed-income holdings. In that case, a milder-mannered offering with greater exposure to government bonds and high quality debt may be more appropriate. An example of this would be the Bronze-rated Pimco UK Income Bond fund which holds approximately half its assets in government debt.
Question 3: Do I fully understand the strategy and its implications?
Once you've homed in on what subtype of strategic bond fund you'd like to investigate further, the next step is to make sure you fully understand the strategy and its implications for your portfolio's risk/reward profile. Here are the key factors to assess:
Credit Exposure:- This tends to be one of the biggest differentiators for strategic bonds funds and in turn their risk/reward profiles. Many funds in the strategic bond sector started life as members of this sector’s now defunct forerunner – ‘UK Other Bond’. To qualify for inclusion in this erstwhile peer group, funds had to hold a minimum portion of their assets in high yield (more commonly known as junk) bonds. Despite the demise of this sector, many older strategic bonds funds continue to place high proportions of their portfolios in junk bonds. In contrast, other funds are less tied to the restrictions of the past and are able to vary the credit quality of the portfolio to capitalise on opportunities across the credit range. An example of this latter approach is the GLG Strategic Bond fund, rated Bronze by Morningstar. Managed by a team that includes a highly regarded hedge fund manager, this relatively new fund has great flexibility to adjust the exposure of the portfolio to current market conditions.
Market Maturity: Most strategic bond funds give themselves the leeway to adjust the interest rate exposure of the portfolio to protect or profit from changes in short and long term interest rates. The degree of flexibility and the skill of the manager will determine the return investors receive throughout the market cycle. Other funds are less flexible and tend to maintain their maturity profile within a tight range. These latter funds will tend to provide more predictable outcomes but are typically less able to protect capital or exploit opportunities that arise from interest rate changes.
Derivatives: While credit quality and market maturity will tend to be the biggest determinants of strategic bond funds' risk/reward profiles, funds also vary in their use of derivatives to manage both the interest rate, credit quality and currency exposure of the portfolio. The use of derivatives can significantly increase the flexibility of the portfolio and provide the manager with additional tools to protect capital. Equally derivatives can reduce the transparency of the investment process and make it less easy to predict the impact of market events. Silver-rated Henderson Preference & Bond is an example of a fund that makes significant use of derivatives. Managers Jenna Barnard and John Pattullo use these tools to position the portfolio in line with their macroeconomic and market outlook.
Question 4: What's an appropriate allocation?
Once you've found the right fund and researched its strategy, the next step is to consider how much of your portfolio to invest in it. The answer depends on the type of fund you've chosen.
If you've opted for a more aggressively positioned fund, especially one that invests significantly in high yield, then it makes sense to keep your position to a fairly modest size. You should also consider reducing this exposure as you reach retirement as the increased volatility associated with these more aggressive funds can work against you as you start drawing an income from your portfolio.
However, if you've opted for a mild-mannered, strategic bond fund that is well diversified and able to adapt to changing market conditions you could arguably maintain a substantially higher weighting, not only during your accumulation years but during retirement as well.
As ever when selecting funds, the key is to look beyond the headline description and see what is really happening in the portfolio before committing any capital. By asking these four simple questions you should be able to find the right strategic bond fund for you.
This article was co-authored by Dan Kemp and Christine Benz.
