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The best flexible bond funds for income and mitigating market crashes

Strategic and Global Bond funds can mitigate downside and provide an attractive income
The best flexible bond funds for income and mitigating market crashes
  • Flexible bond funds are a good way to access this asset but the options differ massively
  • The key differences and how to find a fund to meet your needs

Bonds have proved once again proved their worth in 2020. Government bonds were one of the few assets to protect investors during the sharp sell-off in February and March, and have continued to hold up well during recent bouts of equity volatility. Riskier bonds such as investment grade credit, and high yield and emerging market debt have looked more attractive in terms of yield and price in the wake of the March sell-off.

But fixed income comes with several drawbacks. Government bonds continue to look extremely expensive, leaving them with unattractive yields and highly vulnerable to a sell-off. Higher income subsectors such as high yield, meanwhile, can be highly correlated to equity markets and carry hefty risks. And understanding the prospects for either of these areas can be a difficult task.

So flexible bond funds continue to stand out as good way to invest in this asset. While they tend to charge higher fees, they can use more tools to manage risk and invest in more areas than bond funds with a narrower remit.  But no one flexible bond fund is alike so picking the best one for your investment purposes requires substantial research.

 

Currency and other risks

Many of the better known flexible bond funds fall into the Investment Association (IA) Sterling Strategic Bond sector. Funds in this sector must have at least 80 per cent of their assets in bonds that are denominated in sterling or hedged back to this currency. Similar restrictions apply to the IA Sterling High Yield and Sterling Corporate Bond sectors.

Such limits could be useful if you want a source of sterling exposure in your portfolio. With Brexit talks again at a critical juncture, any clarity could mean better prospects for the currency and sterling assets in your portfolio. But if you want a greater focus on overseas currencies consider IA Global Bonds sector funds, though these can add additional complications to your investments.

Darius McDermott, managing director of fund research company FundCalibre, notes: “The clear difference is the currency. If you have loads of US debt you have fluctuating currency [which] can be accretive but also detrimental to returns. That’s the key factor, so clients prefer Sterling Strategic Bond funds. It’s a big sector and reasonably well understood.”

The Global Bonds sector is even larger with 190 funds compared with 97 Sterling Strategic Bond funds. The Global Bonds sector also includes all manner of different bond funds so the IA is looking at splitting this sector into a number of different ones.

 

What they do

Currency can be a consideration but other factors should also influence your choice of fund. As with any position, it is essential to define exactly what you are looking to get from a holding.

Investors generally tend hold bond funds for one of two main purposes. Some fixed income exposure – especially government bonds – can work as a diversifier against equities. And some investors hold racier types of bonds for income.

As the chart shows, funds such as Allianz Strategic Bond (GB00B06T9362and M&G Global Macro Bond (GB00B78PGS53) have held up well in times of market stress. Each posted a positive sterling return during the sell-off in February and March this year, and when markets slumped in the fourth quarter of 2018.

These have notably different objectives. Mike Riddell, who runs Allianz Strategic Bond, specifically targets a correlation of 0 with global equities over rolling three-year periods, and uses a wide range of tools including derivatives and currency positions to account for different market conditions. As we noted in the issue of 21 August, the team took short positions on corporate bonds, betting on values falling, as well as using defensive currency positions in the run-up to this year's sell-off.

The M&G fund does not explicitly state a commitment to capital preservation, but rather seeks a combination of income and growth via a flexible global approach. As a constituent of the IA Global Bonds sector, this fund may benefit from exposure to currencies such as the US Dollar and Japanese Yen that often rise in times of market stress.

Some flexible bond funds are likely to struggle less than some of their peers in a sell-off. Ariel Bezalel, manager of Jupiter Strategic Bond (GB00BN8T5596), has been cautious about the state of the global economy in recent years so has allocated a good portion of the fund's assets to more defensive bonds. Paul Angell, investment research analyst at Square Mile, views Janus Henderson Strategic Bond (GB0007502080) and Artemis Strategic Bond (GB00B2PLJS27) as defensive holdings because of their flexible investment processes.

 

 

Various indicators can help investors identify funds that may act more defensively at times of equity market stress. Checking how they held up in sell-offs can be instructive, as can a fund’s investment objectives. Defensive bond funds are less likely to explicitly target a high yield though some, such as Janus Henderson Strategic Bond, also generate a good level of income. Such funds may also have no or less exposure to riskier debt such as high yield, with a greater chance that they hold government bonds and investment grade credit. Fund manager commentaries can tell you how they feel about the state of markets and what they are attempting to achieve with the fund.

Mr Angell stresses the need to pick defensive funds that are truly active and flexible, and whose investment teams take views on issues such as a portfolio's sensitivity to interest rate changes.

"If investors want a through the cycle return they need to look at how active a manager has been through time," he says. You can't just see the word 'strategic' on the tin and presume it will be actively managed – you need to check it's being managed that way. Look at returns and environments where they perform."

Fund managers can express defensive views in different ways, from buying different bonds to taking views on duration and currencies, and even short selling bonds and bond indices.

 

Income plays

As the chart shows, several flexible bond funds have offered extremely high yields in recent history. Names such as Royal London Sterling Extra Yield Bond (IE00BG5GTJ66) and Invesco Monthly Income Plus (GB00B8N45Q51) have listed yields of more than 5 per cent. At a time when the yield available from equities is much lower and much less assured, bonds are one possible way to boost your income.

 

 

The source of yield and the risk involved can be important. Royal London Sterling Extra Yield Bond has a good long-term track record but its heavy focus on high yield bonds leaves it exposed to losses at times of volatility. The fund fell nearly 20 per cent during the sell-off in February and March but has performed strongly as markets have recovered. A Global Bond fund run by the same team, Royal London Global Bond Opportunities (IE00BYTYX230), has had a similar performance.

Invesco Monthly Income Plus, whose management team includes experienced bond investor Paul Causer, has a distribution yield of more than 5 per cent from a portfolio of corporate bonds with a “modest” allocation to equities. It also has heavy exposure to high yield bonds which have a quality rating of BB or lower. Like some other strategic bond funds it also has material exposure to BBB bonds – the lowest-ranked investment grade bonds.

Some higher-yielding funds have a good spread of assets that may provide diversification benefits. MI TwentyFour Dynamic Bond (GB00B57TXN82), which has a yield of more than 4 per cent, has exposure to better known forms of debt such as US and European high yield, and government bonds. But its managers also invest it in more esoteric assets such as asset-backed securities.

 

Simple or complex

Flexible bond funds vary in terms of their complexity. For example, the managers of funds such as Baillie Gifford Strategic Bond (GB0005947741) and Schroder Strategic Credit (GB00B11DP098) tend to focus on picking attractive corporate bonds. But macro funds like Allianz Strategic Bond try to take advantage of economic shifts such as countries' different interest rates and inflation levels.

 Allianz Strategic Bond is not the only fund which takes a macro approach. Nomura Global Dynamic Bond (IE00BF4KSV76) and M&G Global Macro Bond, for example, also do this. You could choose bond funds based on whether you are attempting to shield your portfolio from macroeconomic developments or want a simpler approach.

As with any fund that can invest in multiple regions and markets, flexible bond funds can overlap with other holdings in your portfolio. For example, if you already have a government or high yield bond fund, a flexible bond fund could duplicate some of its exposure.

When using a macro or more thematically driven fund check that its manager’s views chime with your own. If you are bearish about the state of the global economy, for example, funds such as Jupiter Strategic Bond may be relevant.

Flexible bond funds can be difficult to compare with one another. Some break down their exposures in different ways on their factsheets, for example, according to the general type of bond they hold or credit rating.

Because these bond sectors are so disparate there is little point in comparing a flexible bond fund’s performance with the average return of its peer group. It may be more useful to compare defensive strategic bond funds with gilt funds, and some of the riskier, higher-yielding funds against the IA Sterling High Yield sector.