Asset managers peddle £50bn in the wrong type of duration

More than £50bn worth of net inflows into short duration bond funds has missed out on the outperformance of long duration over the last three consecutive years, although investment managers are split on whether long-dated, low-coupon bonds are still “dangerous” or remain an important building block in portfolios.

BMO Global Asset Management analysis of 12 major market Investment Association sectors reveals the Sterling Corporate Bond sector had the most constituents delivering consistent top-quartile performance. In total, six funds, representing 7.7% of the sector, have ranked top quartile in each of the last three years. That compares to 2.3% across all sectors analysed.

In the face of dovish central banks, long duration fixed income funds continue to dominate the consistency tables, the report added.

Duration of the consistent performers in IA £ Corporate Bond sector

Source: BMO Gam based on three consecutive years of top-quartile performance

That is at odds with where investors have been putting their money.

Within the universe of fixed income funds available to UK investors, £202bn is currently invested in products with duration of less than three years, while just £18.4bn is invested in funds with duration higher than 10 years, according to Morningstar data. Over three years, net flows into short duration funds have totalled £52.8bn whereas long duration funds have generated just £1.6bn of sales.

Short duration remains an opportunity

Asset managers have launched a spate of short duration bond funds in the period covered by the BMO Gam analysis.

Morningstar does not have a specific category for short duration bond funds, but over the last three years, 17 funds with effective duration less than three years have been launched for UK investors attracting £7.9bn over that time. The £261.9m Canlife Short Duration Corporate Bond and £130.3m Fidelity Short Dated Corporate Bond funds were the two UK-domiciled launches Morningstar had registered over the period.

In contrast, Allianz Index-Linked Gilt and Nordea 1 Emerging Market Debt, domiciled in the UK and Luxembourg respectively, are the only fund launches from the last three years with duration above 10 years.

Architas senior investment manager Nathan Sweeney understands why asset managers have focused on short duration products even though the fixed income bucket in the multi-manager’s range is running with duration close to the benchmark.

For UK gilts that’s 11.5 years, while for global bonds and UK corporate bonds it’s eight years based on the Evalue strategic asset allocation model used by Architas.

“From a pure distribution perspective, you’ve got to seek the opportunity,” Sweeney says. “There is an opportunity in launching short duration bond funds because it’s obvious rates will raise at some point. For fund houses having such a product in their tool kit makes sense because when investors do want it they will have that product to hand.”

Long duration could deliver 20% losses

In contrast to Architas, Psigma is one of the investment managers “deliberately short” when it comes to duration, according to head of investment strategy Rory McPherson.

Semper Total Return, which invests in non-agency US mortgages, has the lowest duration of any fund within Psigma’s portfolios at 1.1 years. At the other end of the spectrum, the Allianz Gilt Yield has a duration around 12 years, but only features as a relatively small portion of Psigma’s cautious portfolios.

“We think it is dangerous to expose cautious portfolios heavily to long-dated bonds,” McPherson says. “These now offer very little in the way of coupon but could quite conceivably deliver capital losses of the order of 20% plus.”

Cautious portfolios currently run with duration around three years at Psigma, while in balanced portfolios it runs at 1.2 years.

Inflation informs duration views at Schroders

Among the consistent performers in BMO Gam’s analysis, Schroder Long Dated Corporate Bond, Pimco GIS UK Long Term Corporate Bond and BMO Long Dated Sterling Corporate Bond have policies to go long duration.

Schroder fund manager Alix Stewart currently runs duration at 15.66 years, 0.46 years longer than the benchmark.

Stewart says: “I have generally been long duration for most of the past three years on the view that the global economy faced structural headwinds and inflation would remain benign meaning interest rates would have to stay lower for longer and particularly in the UK with the uncertainty caused by the Brexit vote and subsequent difficulties in enacting an orderly Brexit.”

However, she has trimmed back a little recently because expectations for much more dovish central banks were more fully reflected in bond prices.

Inflation informs Sweeney’s thinking on duration at Architas too. “The key question people need to ask is ‘is there inflation’ as opposed to buying short duration because valuations on bonds look expensive, because they have gone up so much and interest rates are at such a low level. The fact of the matter is without inflation central banks are not going to react.”

Until recently, the US Fed had been the only major central bank tightening rates, but it is now signalling a rate cut due the lack of inflation, he says.

Corporate versus strategic bond fund duration

Compared to the Sterling Corporate Bond sector, only two funds in the Sterling Strategic Bond sector were highlighted by BMO Gam for consistent performance: the Baillie Gifford Strategic Bond and Royal London Global Bond Opportunities. In the IA Global Bonds sector there were no consistent performers, according to BMO Gam.

IA £ Strategic Bond sector consistent performers

Source: BMO Gam based on three consecutive years of top-quartile performance

Baillie Gifford manager Torcail Stewart says Sterling Corporate Bond funds are focused primarily on investment grade securities with maturities upwards of 10 years into the future and therefore duration tends to range from eight to 13 years.

The Baillie Gifford Strategic Bond fund currently has duration of six years, although Stewart notes this is a bit higher than some of its Sterling Strategic Bond sector peers. “This is because when we identify a company where we believe there is a high chance of balance sheet improvement, then we seek to buy the longer dated bonds of that company.”

At Royal London Asset Management, which had a consistent performer in both sectors, the same trend applies with Paola Binns running duration around 7.9 years in her Sterling Corporate Bond sector fund, while Rachid Semaoune and Eric Holt, whose Global Bond Opportunities fund sits in the Sterling Strategic Bond sector, have duration around four years.

Binns’ fund in particular has benefited from higher interest rate sensitivity than its peers, but sector and stock selection has also contributed to the outperformance highlighted in the BMO Gam analysis, says RLAM head of fixed income Jonathan Platt.

Fidelity International also says it tweaks duration at the margin, but that credit selection had added to outperformance against its peers. The bulk of its duration is in sterling at 7.8 years with the remainder in Japan and the US dollar.

Downside protection and higher yield

Duration can be used as a portfolio construction tool alongside a call on monetary policy.

Vanguard analysis shows long-term investors are better served in long duration bonds even in a rising interest rate environment, says senior investment strategist at the asset manager Ankul Daga.

“If the markets behave exactly as anticipated, in most market environments, longer duration bonds would give investors a higher yield than a short duration bond,” Daga says. “And while short-term bonds may be less sensitive to interest rate rises, they offer reduced protection during periods of economic uncertainty along with lower income.”

The year to date is a case in point about how difficult it is to predict markets, Daga says. “Economic data has been weaker than expected, we are burdened with the growing tax of trade wars and continued uncertainty regarding Brexit. In this environment, long duration bonds have done what they do best; provide a cushion to the portfolio when it needs it the most.”

Short duration bond funds could also be used a cash alternative in a falling interest rate environment, according to Morningstar senior manager research analyst Louise Babin. “Some investors may be seeking higher returns than those available on cash but taking on a little more duration in short duration bond funds.”