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Best bond funds for difficult times

Bond prices have tumbled over the past month as investors fear a scaling back of US quantitative easing. So what does this mean for investors in bond funds?
July 3, 2013

Earlier this year we reported on how investor enthusiasm had cooled leading to concerns on liquidity on some of the larger bond funds (read more on this). Since then US central bank chairman Ben Bernanke has thrown another spanner in the works by hinting that he will slow its quantitative easing programme, sparking selling across financial markets, and making bond prices fall and yields shoot up. But while rising yields may sound attractive to income investors, they mean falling prices so some capital losses will occur.

This makes it even more difficult for private investors to know what to do with their portfolio allocation. Traditionally, balanced portfolios should contain some fixed income as a diversifier from equities, while lower-risk investors have relied more heavily on bonds both for income and growth.

For a number of investors there remains an obvious, if not original, answer: strategic bond funds.

These 'go anywhere' bond funds have been popular with investors for a number of years (read what we said last year) because of their ability to move in and out of different fixed-income asset classes, and perhaps more importantly, steering clear of risky areas. This of course relies on the fund manager making the right investment decisions, but there are strategic bond funds whose managers have succeeded in doing this, some of which you will find in our IC Top 100 Funds.

"We prefer strategic bond funds because the manager has more flexibility," says Darius McDermott, managing director at discount stock broker Chelsea Financial Services. "These can invest in a variety of areas including high yield, cash, convertibles and floating rate notes, plus they can manage their durations [the amount of time it takes for a bond to be repaid] better, which helps to manage interest rate risk. This doesn't mean they won't see their value fall, but the managers have more tools in their bag to try to minimise capital losses for their investors."

Robert Pemberton, investment director at HFM Columbus, believes that investors should avoid exposure to long duration bonds as these are far more sensitive to interest rate movements.

"We recommend holding fixed-income exposure through strategic bond funds with short durations, and an emphasis on preserving capital and producing income rather than chasing capital growth through having a long duration," he says. "There is very limited prospect of capital growth in the asset class as yields have fallen significantly from the current levels. After a 30-year cycle of falling yields to record low levels we think that the next major move will be upwards causing a fall in the price of existing bonds. But short-dated bonds can be held as cash plus investments with a low risk/reward return profile to reduce volatility and increase diversification in portfolios."

Strategic bond funds have a number of other advantages: choosing which different type of bond funds to allocate to, and in what proportions, whether government, high yield or corporate is generally more difficult than choosing equity funds because so much macroeconomic research is needed. Private investors cannot necessarily access all the different types of fixed income available via a single sector bond, for example, mortgage and asset-backed securities. But a strategic bond fund is like a one-stop shop: the investment team, which will encompass tens or hundreds of people including an economist and various types of analyst, research and make the allocation for you, as well as constantly monitoring and moving it around when appropriate.

This is particularly useful for investors with smaller portfolios, for example individual savings accounts (Isas) in the early stages which do not yet have enough assets to allocate across various funds. One strategic bond fund can give you a good spread of what are hopefully the better areas of fixed income at present. However, if a substantial portion of your portfolio - for example, around 40 per cent or more - is allocated to fixed income, you could split the allocation between three or four strategic bond funds. This can be particularly relevant because while these funds are categorised together in one Investment Management Association (IMA) sector, they do things quite differently to each other.

For this reason, before you invest in one of these funds it is very important that you check the fund literature to see what it does, what its current allocation is and what it could potentially invest in going ahead.

 

Best strategic bond funds

Mr Pemberton recommends JPMorgan Strategic Bond (GB00B3RJ9K34) for its low risk/return cash plus objective (read our tip). He also suggests Jupiter Strategic Bond (GB00B2RBBC80) (read our tip) and IC Top 100 Fund M&G Optimal Income (GB00B1H05049) for the quality and experience of their managers who have proved very successful and adept at managing bond portfolios over a number of years.

Jupiter Strategic Bond is among the top five performing funds in the Sterling Strategic Bond fund sector over three and five years, and offers an attractive yield of 5.52 per cent.

Mr McDermott likes Artemis Strategic Bond Fund (GB00B09DMK36). "We have always favoured strategic bond funds, but their flexibility is even more important at this tricky time for fixed interest investing," he says. "The fund managers, who are very experienced bond investors, have a highly flexible mandate which allows them to shift between the various fixed interest asset classes and employ shorting, as market conditions dictate." Artemis Strategic Bond's managers are keeping its duration low.

Strategic bond funds

Fund

1 year cumulative total return (%)

3 year cumulative total return (%)

5 year cumulative total return (%)

Yield (%)

Total expene ratio (%)

Artemis Strategic Bond Q Inc

10.1724.8639.47

4.42

1.09

JPM Strategic Bond A Net Acc

1.912.34NA

3.27

1.18

Jupiter Strategic Bond Acc

8.8329.9570.33

5.34

1.49

M&G Optimal Income A Inc

9.4327.5167.83

2.94

1.41

M&G UK Inflation Linked Corporate Bond GBP A Inc

5.47NANA

0.62

1.17

Peer Group Average

8

20.46

39.20

Source: Morningstar

Performance data as at 1 July 2013