A bond fund for all seasons

With corporate bonds down from their peak levels, concerns over UK and eurozone debt, and economists unsure whether the global economy will experience high inflation or another lurch downwards into recession, it is difficult to know what kind of bond funds to hold in the fixed-income part of a portfolio. But there is a solution: try sterling strategic bond funds.

Unlike other categories of bond funds where managers have to invest most of their cash in one type of bond, such as UK corporates or gilts, strategic bond funds can invest in many types of bonds as long as they are sterling-denominated or hedged against sterling, and can change their allocation quickly and frequently to react to market conditions. For example, when returns on corporate bonds are low, a sterling strategic bond fund could be heavily invested in high-yield bonds, an asset class that is also useful in times of rising inflation thanks to the higher yield they offer. This makes strategic bond funds a good option when the outlook for inflation is uncertain, such as now.

On the other hand, if there is widespread doubt about the quality of corporate debt, a strategic bond fund could become defensive, with a heavy allocation in government bonds.

Another advantage of holding a strategic bond fund is that investors don't have to reallocate capital between bond funds as circumstances change. With the rise in capital gains tax to 28 per cent for those in the highest income tax bands, this could be an advantage - investors just buy and hold a strategic bond fund, rather than switch between bond funds of different sorts.

It is also harder for single investors to determine bond allocation because researching bonds is tougher than researching shares. It requires a lot of macro-economic research as well as company research. Bond funds are often managed by whole teams rather than one manager, with substantial input from economists.

One of the best performing strategic bonds funds, and a favourite with financial advisers, is the Legal & General (L&G) Dynamic Bond Trust. Over the past three years it is the top performer in its sector, and broker The Share Centre, which includes this fund on its Platinum 120 list of favoured funds, says: "In terms of performance since launch, the fund manager has clearly demonstrated an ability not only to outperform in rising markets, but to minimise losses during very tough economic conditions."

The fund proved its worth in 2008, losing only 1.6 per cent against a 13.1 per cent loss for its sector; while in 2009 its return was more than double its sector average - 42 per cent against 20 per cent.

It aims for capital growth as well as providing good income and typical holdings include investment-grade and sub-investment-grade corporate bonds, sovereign bonds and credit default swaps. L&G Dynamic Bond Trust also uses swaps, hedging and derivatives both for asset allocation and protection in falling markets. Risk management is an important part of the management process with credit and interest rate risk managed independently

True, this L&G bond trust does not have much of a history, launched just over three years ago. However, its manager, Richard Hodges, has more than 21 years of fund management experience, especially at Gartmore, where he was a senior investment manager and head of pan-European portfolio construction. The L&G fund also draws upon the expertise of Legal & General's fixed-income team of 48 analysts.

The downside to strategic bonds funds is that it is difficult to quantify their risk and volatility, because they can invest in a wide range of bonds and the nature of the fund can change drastically even over the space of a few months. That said, it is this ability to continually change profile that allows these funds to achieve results, and short-term volatility should not trouble the long-term investors for whom such a fund is suited. Buy.

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