Take a strategic approach to bonds

The IMA figures are telling: as confidence returns investors are again looking at sectors such as property and equities. But for many an allocation to bonds is still necessary, say advisers, in particular older clients nearer to retirement who need a lower-risk portfolio to preserve their pension pot. In addition, cash is not offering comparable yields to bonds as interest rates are kept on hold at 0.5 per cent - not nearly sufficient for those who need to make a return on their capital to provide an income.

"The part bond funds play in your portfolio depends on your financial objective, but you should always have a core element allocated to corporate bonds - especially if income if your objective," says Ben Willis, investment manager at Whitechurch Securities.

So where to next for bond funds?

Jon Cunliffe, head of interest rates at Aberdeen Asset Management, says that while the world is certainly not facing the armageddon scenario markets were previously pricing in, the recovery is still fragile. "Consequently next year we do not envisage the same level of returns and degree of correlation between asset classes. Investors will need to be flexible and have exposure to a diverse range of bonds either through one fund with a broad remit or via a range of different fixed income funds," he adds.

Many independent financial advisers (IFAs) are suggesting a switch from a Sterling Corporate Bond Fund into a Sterling Strategic Bond fund. Darius McDermott, managing director of discount stockbroker Chelsea Financial Services, says that while both IMA sectors offer a yield – 5.36 and 4.7 per cent respectively as of 4 December - the major gains in corporate bonds have been made following a rally in this sector, which peaked around March this year. "While certain areas of this market could do well going forward, more normal bond returns are likely, and corporate bonds will revert to making most of their return from yield rather than capital appreciation," he explains.

Last year, with their values down significantly, corporate bond funds were offering unusually high yields making them hugely attractive, and an obvious asset class to invest in. Since then the yields on these funds have fallen significantly from the attractive levels of around the turn of the year.

Investors could look instead at funds with a wider investment remit such as Sterling Strategic bond funds, says Mr McDermott. Funds in this IMA sector can invest in a wide range of securities across the credit spectrum, whereas Sterling Corporate Bond funds are required to put a minimum of 80 per cent of their assets into investment grade bonds – bonds rated triple BBB minus or higher by a ratings agency such as Standard & Poor’s or Moody’s.

Sterling Strategic Bonds funds are allowed to invest unlimited amounts in high-yield bonds. This flexibility has helped the sector along in terms of performance. The Corporate Bond sector returned 18 per cent over the year to 20 November, while the IMA Sterling Strategic sector, helped by its wider remit, returned 22.9 per cent over the same period. Sterling High Yield did even better with a 40.6 per cent return but as this is a higher risk category it cannot form a substantial part of many investors' portfolios.

Strategic bond funds can also make use of derivatives such as swaps for protection and asset allocation, as well as extra hedging. These funds allocate throughout the cycle, explains John Patullo, manager of the Henderson Strategic Bond Fund, making them more flexible and better able to exploit current opportunities and respond to economic conditions.

Generally speaking, Mr Patullo says that bond investors should focus on investment grade bonds early in a recovery, high yield bonds mid to late in the cycle and cash or defensive credits at the top - something which a strategic bond fund is able to do.

Holding a strategic bond fund means you do not need to change funds over the cycle and because they allocate across different types of bonds, investors also do not have to choose various different types of bond funds to get a diversified bond investment allocation into their portfolio. Instead this is left to the fund manager and specialist investment teams who do the allocation within the fund.

Mr Willis adds that due to the financial crisis, bond allocation has become even more complicated.

But spread your risk

A downside to the broad investment mandate of the funds in Sterling Strategic Bond sector is that they can be very different to each other in terms of underlying investments and risk, making it harder for investors to choose one. Mr Willis says it is important to be clear on the nature of the underlying holdings because the risk rating of funds in this sector can vary widely.

For example, Invesco Perpetual's Monthly Income Plus Fund can allocate up to 20 per cent to equities and these accounted for 16 per cent of its portfolio as of the end of October. M&G Optimal Income, meanwhile, tends to be more weighted to investment grade bonds than some of its peers and currently has more than 68 per cent of its holdings in this area, with only 20.5 per cent in high yield.

Consequently, Mr Willis suggests investing in a range of strategic bond funds. He favours funds run by managers with a good record. He suggests the Jupiter Strategic Corporate Bond Fund, which while just over a year old, is run by Ariel Bezalel, who has worked in the Jupiter fixed interest team since 1998 and runs the fixed interest component of a number of other funds.

Mr Willis also likes the Artemis Strategic Bond run by James Foster who has run bond funds for 17 years. The fund is currently substantially weighted to financials - more than 48 per cent of the portfolio as at 30 October. Another favourite on Mr Willis' list is the Invesco Perpetual Monthly Income Plus Fund run by Paul Causer, Paul Read and respected equity manager Neil Woodford - he rates the fund for its good short-term calls.

Corporates: still worth consideration

Given the varying mandates of Sterling Strategic Bond funds, Mick Gilligan, head of research at stockbroker, Killik & Co, says he does not consider bond funds in terms of sector because they are not directly comparable. Instead he assesses funds individually to see if they fit a client.

According to Mr Gilligan there are a number of funds which can spread credit and interest rate risk with derivatives by going short, and in general, funds can manage the average duration of their holdings much more easily than five to 10 years ago. Funds he recommends include the L&G Dynamic Bond in the Sterling Strategic Bond sector, with safeguards against both credit and interest rate risk with what Mr Gilligan describes as "more of an absolute return approach".

However, he also favours two funds within the Corporate Bond sector: Invesco Perpetual Corporate Bond and M&G Strategic Corporate Bond, lauding their managers for being mindful of credit and interest rate risk in their allocations, as well as having good long-term track records and managing their funds with a medium-term view.

There is also a wider choice of funds within the Sterling Corporate Bond sector - 90 as opposed to 64. Although in terms of performance over one, three and five years Sterling Strategic has outperformed Sterling Corporate.

Mr Gilligan also argues that while the average spread of UK corporate bonds over UK Gilts has fallen from a high of more than 4 per cent to around 1.8 per cent, there is still a good deal of value in these. From a historical perspective 1.8 per cent over gilts is not bad because even as recently as 2003 many of these bonds paid a coupon of less than one per cent over gilts.

He adds that the current credit spread implies a much higher level of defaults than expected, still making these good value. The improving financial health of companies also means they are more likely to be able to maintain their coupon payments, while issuance is likely to fall in the next year to 18 months which could tighten spreads over government bonds even further.