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Flexible bond funds and the balance of risk

Funds with a flexible approach weigh up different risks
Flexible bond funds and the balance of risk
  • A number of strategic bond funds have a substantial allocation to government bonds
  • Some strategic bond funds have a large exposure to high-yield bonds
  • Both these types of bonds face risks

With inflation and rate rises continuing to dominate the agenda, a bad spell for equities has proven even tougher for bonds. Government debt, for example, has been hit with the average fund in the Investment Association UK Gilts sector racking up a 16.1 per cent loss over the six months to 8 June. That’s more than twice the 7.5 per cent fall in the MSCI World index of equities.

As ever in a sell-off, talk of more attractive valuations emerging has already begun. Several professional fund investors have begun to buy into defensive parts of the fixed income universe, including government and investment grade bonds. Lower prices offer something of a buffer while the accompanying rise in yields means some bonds look more attractive from an income perspective. To take a flagship government bond as an example, the US 10-year Treasury's yield hit 3 per cent in recent months – the first time it has reached such a level since late 2018.

If some investors are simply steering clear of bonds, others may well be sticking with residual allocations, or considering buying in with a contrarian mindset. While subsectors can offer targeted exposures, it can be worth considering how they might perform in different scenarios. Riskier high-yield bonds are less sensitive to interest rate changes but could struggle if a recession emerges, as some fear. Government bonds may return to form if recession strikes, but will be especially exposed if inflation persists and interest rates continue to rise.

Flexible bond funds tend to be a useful play on fixed income because of their ability to dip in and out of different parts of the market based on changing conditions. With some expecting a potential shift in conditions, it’s worth looking at some of the broad exposures they have taken in recent months. As in our discussions of inflation, we have looked at recent updates from some of the biggest strategic bond funds, with a view to assessing some important allocations.

 

Defensives

Strategic bond funds tend to disclose their asset allocations in highly idiosyncratic ways, so it is difficult to make a like-for-like comparison of them. But some very rough indicators offer hints about their positioning.

One of these is just how exposed the broader funds are to government bonds, which have taken a battering in recent months but might now look more attractively priced.

As the chart shows, many of the more balanced funds have decent, but not overwhelming, allocations to government debt. Jupiter Strategic Bond (GB00BN8T5935), whose manager Ariel Bezalel has long argued that structural factors such as advances in technology and shifting demographics should suppress inflation in the longer term, tends to run a 'barbell' approach of diversified allocations. That appears to remain the case – as with other funds on the list it has stuck to a similar weighting to around a year ago. MI TwentyFour Dynamic Bond (GB00B5VRV677) had the lowest government bond allocation, and continues to spread its money across a variety of sometimes niche fixed income investments, including asset-backed securities.

Allianz Strategic Bond (GB00B06T9362) deliberately seeks to act as a diversifer against global equities. While it invests heavily in government bonds its stated allocation can be misleading about how the fund works. Mike Riddell, the fund's manager, often uses all manner of different instruments to navigate changing macroeconomic conditions, from currency exposures to derivatives. It can therefore position for falls (and recoveries) in different parts of the bond market, something that Riddell did successfully earlier on in the pandemic.

The performance of the bigger strategic bond funds tells us just how much nuance can be involved in their positioning. Of the 10 names we looked at last year, it’s the corporate bond-focused Baillie Gifford Strategic Bond (GB0005947857) that has fared worst in the six months to 8 June, with a negative return of 11.7 per cent. Janus Henderson Strategic Bond (GB0007533820) and the Jupiter fund also made double-digit losses, with Allianz Strategic Bond down just shy of 9 per cent. Generally speaking, it has been high yield-focused names like Royal London Sterling Extra Yield Bond (IE00BD0NCB41) that have fared better.

 

Where credit’s due

If riskier bonds have fared better, an economic downturn could prove painful for them as discussed. It can also be worth paying attention to how much money a fund manager has in BBB-rated bonds. The lowest rung of investment grade debt, these can be vulnerable to deteriorating conditions and a tumble into the high-yield category, something that can hurt performance in the short term at very least.

If Invesco Monthly Income Plus (GB00BJ04JZ25), Artemis Strategic Bond (GB00BJT0KV40) and Royal London Sterling Extra Yield Bond tend to be known for having a higher yield so depend to an extent on riskier credit, it’s still Jupiter Strategic Bond that stands out most with its exposure to high-yield bonds. They made up nearly 60 per cent of the fund at the end of April and it also had a modest exposure to BBB debt.

M&G Optimal Income (GB00B1H05718), another fund that can at times take a defensive approach, is notable for its BBB exposure, as is lesser known Muzinich Global Tactical Credit (IE00BYV1C692). Overall, names like Artemis Strategic Bond have a hefty exposure to both.

As noted before, such allocations can indicate how a manager is thinking but much more detail is also useful. It’s worth pointing out, for example, that credit quality breakdowns in these funds can apply either across the whole portfolio or just to certain subsectors. It’s also worth checking manager commentaries where possible, to see where a fund is currently focused. Our piece last year, 'How bond funds are facing the inflation threat' sums up how different teams were viewing the threat of inflation at the time.