If you are looking to invest in a diversified, flexible fixed-income fund that aims to deliver positive alpha through a variety of economic environments, you might consider a fund within the IA Sterling Strategic Bond sector.
The sole criterion for inclusion within this sector is that at least 80% of a fund’s assets must be invested in sterling-denominated or sterling-hedged fixed-income securities, which helps to reduce the currency risk for UK investors.
Strategies within this sector are able to invest dynamically across different geographic locations, sectors and asset classes. The funds can also take varying levels of risk through exposure to credit and interest rates. They may invest into anything from developed market government bonds to high-yield corporate bonds and even equities (at a maximum of 20%). Strategic bond funds do not tend to use an index for asset allocation or performance-related comparison, meaning they are unconstrained when it comes to the shape of their portfolios.
Divergence and adapting strategies
‘Divergence’ is the key word for the current macroeconomic environment. We have heard contradictory views on expectations for a US recession. Some managers are looking at US payroll and unemployment data, which signals a soft landing and recessionary fears being overblown. Others are comparing current US treasury yield curves versus history and stipulating that while history does not repeat itself, it does rhyme, and are betting on a recession as a result.
We are witnessing a slowing US economy, a eurozone that is virtually stagnant and a UK that is uninspiring, and looking for the future catalyst that will spark growth.
Divergence, unfortunately, could mean added volatility. So, as we enter this new macroeconomic environment of rate cuts, investors making use of strategic bond funds may benefit by allowing managers to actively select the right assets at the right time to provide either capital preservation or appreciation. Divergence is the time when active fund management comes into its own.
Future drivers
Due to the Federal Reserve’s relentless ‘pause, pause, pause’ stance on interest rate cuts until recently, the impact on the consumer has become more profound. For this reason we cannot yet rule out a hard landing, which presents a tail risk for markets. As a result, many fund managers have continued to hold higher-duration risk as a successful play since May. The focus going forward will be on the labour market, however, which may be a key driver of markets in future.
When it comes to corporates, fundamentals are strong and the technical environment is very supportive, with record issuance of corporate bonds in August and September 2024. This issuance has been well absorbed by the strength of investor appetite, given the high yields on offer. Investors are locking in these yields and receiving a high income, which is proving positive for fund carry returns.
On the other hand, valuations are comparatively rich, and we may need to start to get accustomed to a lower risk premium for credits over government bonds, similar to the tight spread of the mid-2000s.
A common trade used by many managers is curve steepening, as the rate-cut environment facilitates the normalisation of the shape of the yield curves to pick up the extra yield.
Fixed income is therefore offering the potential for capital appreciation, diversification and a strong yield.
Looking ahead, we expect to see investors reallocate from cash into this asset class, while others reallocate from equities, again adding to fixed income on the back of expectations of a potential recession.
The benefits of strategic bond funds lie in their flexible investment mandates and ability to move extremely quickly on the back of economic shocks or market moves. This may prove significant during coming months as we enter into a new regime of monetary policy and geopolitical risks threaten to upset the apparent benign macroeconomic backdrop.
Delivering in a tough market
Strategic bond funds are once again delivering positive returns in 2024, following two years of bruising performance which accompanied a fall in assets under management. In the past 12 months , the tides turned and the sector grew by £2.8bn, and as at the end of August 2024, funds under management stand at £39.3bn, placing it in the top 10 largest IA sectors.
Asset class performance has been relatively individualistic. Credit spreads have remained strong in 2024 but government bond performance has been weaker overall. However, yields have started to fall as new monetary policy comes into play.
The funds that have greater exposure to rates and a bias towards investment-grade credit have underperformed. On the flip side, those with more credit risk, through a greater weight to high yield and subordinated debt, are producing more positive returns.
The story has demonstrated how investors taking on extra duration risk has not resulted in wildly higher returns. Lower-duration funds have performed almost in line with higher-duration ones, but with lower volatility.
Should we see a complacency trend towards credit risk, this could be worrying due to the historically tight spreads and recessionary risks that are still at play despite the resilience of the employment market.
One cannot ignore surprise geopolitical shocks such as the worsening conflict in the Middle East and potential outcomes of the US presidential election. Such events tend to be inflationary and while strategic bond managers remain generally optimistic for the future, there remains a great deal of market uncertainty.
Read the rest of this article, plus Eduardo Sánchez’s funds to watch by assets under management, three-year performance and newcomers in November’s Portfolio Adviser magazine
