In March, AJ Bell made the rare decision to go bonds-free with the income products in its managed portfolio service range, which comes in passive and active options.
The portfolio is instead 70% equities, 25% property and 5% infrastructure.
For conservative clients, CIO Kevin Doran says AJ Bell has exchanged all government bond exposure for short-dated bond positions with a maturity of less than two years.
“For our most cautious portfolio, that’s a 27% asset allocation switch into a bond envelope operating with a duration of just 1.5. It’s a lower expected return, at 0.8%, but more akin to what we believe nervous investors are seeking when they make their investment choice.”
GBI2 managing director Graham Bentley, who sits on the investment committee at Ascot Lloyd and the advisory board at Distribution Technology, says most investment managers would be reluctant to make wholesale changes, such as exiting bonds.
“Nobody would thank you for completely coming out of equities on the expectation that they were going to have a setback, only to find there was no setback and your customers have just lost 15%,” he says.
Tackling duration head on
Distribution Technology head of asset and risk modelling Abhimanyu Chatterjee believes duration risk should be addressed directly in bond portfolios or by allocating to cash, rather than introducing new sources of risk with alternative strategies.
Investment managers have not settled into a pattern when it comes to dealing with interest rate sensitivity in their portfolios, says Chatterjee. “A lot of managers that work with us are trying to reduce duration risk and divesting out of bond holdings to go into cash.”
He says: “We are cognisant of rising interest rate risk in the market but we have to hold some bonds because the negative correlation between equities and bonds has not gone away. We are discussing reducing bonds and increasing cash and equities.”
Orbis uses derivatives to reduce its fixed income exposure without allocating to alternative asset classes.
The Orbis Global Balanced Fund holds 78% gross in equities but that allocation reduces to 59% through futures, bringing the fund in line with its 60% MSCI World Index and 40% JP Morgan Global Government Bond Index benchmark. It holds 19% in fixed income.
Orbis UK director Dan Brocklebank says: “In the event of a significant market drawdown we will get protection from that hedging. Nothing we do in the portfolio is particularly tactical. We’re not sitting there week on week changing it,” Brocklebank says, regarding the fund’s derivatives allocation.
Short duration and floating rate notes
Short-term bonds and floating rate notes can help during a rising-rate environment, according to Chase de Vere research manager Justine Fearns.
The Royal London Short Duration Global High Yield Fund delivers a disproportionate level of income relative to risk and volatility, while Gam Star Credit Opportunities buys into a range of floating rate notes, shorter-dated paper and subordinated debt of investment grade, Fearns says.
But she warns they should not be the sole components of a bond allocation. “They could be paired with a well-diversified, actively managed fund or a well-structured passive, noting that passive funds will suffer the vagaries of the market and will fluctuate accordingly, but over the longer term when used with active funds will help diversify and manage costs,” Fearns says.
M&G Optimal Income uses diversification and derivatives to help protect and grow the portfolio, while Fidelity Extra Income is diversified and defensively managed, she says.
Fearn adds: “Risk is subjective and moves in line with the markets and with sentiment. Some bonds carry more risk when interest rates are rising, in the same way that some equities can carry more risk when inflation is rising, but an asset class should rarely be ignored simply because perceived risk rises.”
Alternative investments
But Seneca Investment Management is switching out of bonds into alternatives.
The Seneca Diversified Income Fund holds 29% in specialist assets and 31.9% in fixed income. According to CIO Peter Elston, these specialist assets include Reits, infrastructure funds, aircraft leasing and direct lending vehicles, such as International Public Partnerships and Doric Nimrod Air Two.
“We are very underweight bonds in relation to our strategic asset allocation. We don’t have government bonds and we don’t have much duration. Where we do invest is somewhere like short-duration high-yield and emerging market debt,” says Elston.
Chatterjee is wary of transferring bond allocations into alternatives. “Most of these aircraft leasings are not very well diversified leases. It’s not similar to holding an ABS, which has 45,000 loans below it,” he says.
Reits hold equity risk and absolute return funds can hold hundreds of positions that require thorough due diligence, he adds.
