Fuelled by a hunt for yield and the anxiety over rising rates, the flexible bond fund space took off in the years immediately following the financial crisis. These funds promised to insulate bond-fund investors from traditional bond-market interest-rate risk while providing returns at least in line with core bond funds.
Strategic bond funds tend to have broader, more flexible investment mandates compared to traditional, core corporate and government-bond funds. They are generally conceived as “go-anywhere” funds with the flexibility to invest across global fixed-income markets, including rates, credit, and currencies. Allocations to these markets are usually actively managed, to be able to best exploit investment opportunities, based on the managers' assessment of the prevailing macroeconomic and market environment.
What is a Strategic Bond Fund?
Flexible bond funds fall under two camps: multisector, income-oriented bond funds; and unconstrained – including absolute return – bond funds. While several funds in the first group have been around since before the global financial crisis, the latter group has been a post-crisis phenomenon.
The key criteria for funds to be included in the £ Strategic Bond sector, as per the UK Investment Association (IA), is to invest at least 80% of their assets in sterling-denominated, or hedged back to sterling, fixed-income securities. This can span across government bonds, and investment-grade and high-yield credit, amongst other bond types. In contrast, other fixed-income IA sectors tend to be more restrictive.
For example, the IA £ Corporate Bond sector requires a minimum 80% of a fund's assets to be invested in sterling-denominated, or hedged back, investment-grade bonds, while the IA UK Gilts requires an even higher 95% of fund assets to be invested in sterling-denominated, or hedged back, government-backed securities, with at least 80% in UK gilts.
Such differences lead to a rather heterogenous IA £ Strategic Bond sector. To better delineate this group and make comparisons more meaningful, we use the Morningstar Categories, which tend to be more focused due to their definitions. The close-to-90 funds in the IA £ Strategic Bond sector map out across 10-plus Morningstar Categories based on the funds' underlying exposures, ranging from GBP Cautious Allocation to Alternative Long/Short Debt.
Post-Crisis Fund Boom
In late 2008, the IA replaced its UK Corporate Bond and UK Other Bond sectors with three new sectors: £ Corporate Bond, £ High Yield, and £ Strategic Bond. The new £ Strategic Bond sector was a more useful classification for an explosion of new fund launches and old strategy revamps following the global financial crisis. These diversified bond funds took more risk – usually credit or country – than standard UK corporate or government-bond funds, which typically serve as core components of UK investors' fixed-income allocations.
These new funds addressed a mounting dread among fixed-income investors: that unprecedented global central bank policy intervention and accompanying low yields would eventually reverse and thus end badly for traditional fixed-income strategies.
To be sure, investors have had reason to be concerned about the impact of rising yields. With yields across sectors near all-time lows today, it wouldn’t take a large increase to result in negative total returns, and marketers have seized on the index's large allocation to government bonds as another reason to abandon core bond funds since the crisis.
Have Flexible Bond Funds Delivered?
Looking at the risk-adjusted returns from January 1, 2009, through March 31, 2017, a period that roughly coincides with the life of the IA £ Strategic Bond sector, results look promising. The average global flexible bond fund (GBP Hedged) managed to edge out the average sterling corporate bond fund, both on an absolute and risk-adjusted basis. It also outperformed both the Bloomberg Barclays Global Aggregate Bond and Sterling Aggregate Bond Indexes over that period. A key driver of this was the strong rebound in riskier fare, such as high-yield bonds, in 2009-10.
Meanwhile, the IA £ Strategic Bond sector marginally lags the sterling corporate bond average, but beats it and the indexes. Risk-adjusted returns for both flexible bond categories, again, fare well over a five-year period, managing to beat the average corporate bond fund and both the aggregate indexes.
Those results shift, however, when we change the trailing time period. If we start in 2011, a year in which credit-sensitive assets struggled amid concerns about the health of European banks and their exposure to Greek government bonds, flexible bond funds look less impressive. If we shorten the measurement period to three years, a time frame that excludes 2013's interest-rate sell-off, flexible bond funds once more appear to lag.
Higher Correlation with Equity Markets
In their efforts to protect investors from rising yields and still produce sufficiently attractive returns, many funds exchange exposure to interest rates for other types of risk. More than 80% of distinct funds in the IA £ Strategic Bond sector have exhibited correlations of at least 0.50 to sterling high-yield corporate bonds during the trailing three-year period, and around 40% have exhibited correlations of 0.80 or higher. Over 60% of the group has exhibited correlations of at least 0.50 to global and UK equities, as represented by the MSCI ACWI All Cap and FTSE 100, respectively.
This is a crucial consideration for investors who are weighing whether to replace at least part of their core bond stake with a flexible bond strategy. While flexible bond funds have displayed low or negative correlations with high-quality bond market risks, their high correlation with equity-market risk hampers their use as a portfolio diversifier.
