Sector analysis: Strategic Bond

Paul Burgin talks to strategic bond managers about the challenging times the sector has recently faced.

Two once-in-a-lifetime events have left strategic bond managers frazzled. They must steer a tricky path to keep yields, capital values and liquidity on track.

When Lehman Brothers collapsed, it set off an unprecedented chain of events in fixed income circles.  Global banks pulled down the shutters and cut off finance. Their own bond issues tumbled in value as investors feared they would go bust. For a while bonds looked more like equities, with the risk premiums to match.

For Sterling Strategic Bond investors, the events were great for yields, but less so for capital values. Funds took a dive from the summer of 2008 to March 2009. They have since recovered, Lipper data shows.

During the storm, brave bond managers saw a buying opportunity, picking up issues for just cents on the dollar. But they had to pick carefully in case firms, including bank issuers, went bust.  Liquidity was the worst many had ever seen. By all accounts, it was a once-in-a-lifetime event.

Thankfully, rescue packages and QE plans brought an element of stability to the market. Liquidity may still be thin yet bond prices have soared since March last year.

That was until things turned for the worst.  Friday 9 May threatened to turn into another once-in-a-lifetime event.

At stake was the euro and fears Greece’s debt problems were spiralling out of control. A combination of factors sent sovereign and corporate bond prices diving. Investors scarpered and another liquidity freeze looked to be a distinct possibility.

Investors feared the IMF and EU rescue would be too little, too late. Their worries were compounded by comments from the ECB’s Jean-Claude Trichet that the central bank had not even considered buying sovereign bonds in the market to get the system working again.

Strategic bond managers think the ECB would have been forced to take action on Greece’s debt in any case. But leaving periphery bank debt to market forces would have brought the system crashing down, they say.

Concerns about Britain’s election results and the implications of a hung Parliament left managers jittery too.

“It has been a challenging time,” admits John Pattullo, co-manager of Henderson’s Strategic Bond funds. “Things reached a crescendo on the Friday night, lots of people were buying protection.”

Some Tier 1 bank issues tumbled 10% during trading as investors sold at any price for cash.  Buyers were extremely thin on the ground.  Market-makers were in no mood to take firm positions and had little capital to do so. Pattullo says other managers in the sector would have been tempted to sell out, potentially crystallising losses.

Rather than follow the herd, Henderson held firm with only marginal trading activity.  Thankfully, the hunch played out well. Pattullo’s strategy has remained mostly unchanged for the last year. The portfolio comprises mainly long banks, insurers and high yield.  Maturities on interest rate risk are shorter.

Over the weekend, it became clear the ECB had left it too late and had to go for the ‘nuclear option’, thinks Pattullo. It belatedly realised the scale of the problem and that leaving banks to fend for themselves will make the crisis much worse. If the banks suffer, the economy suffers.  Further upset would stall any plans to raise taxes to clear Europe’s multiple deficit problems.

The late U-turn dented Trichet’s credibility but had immediate effect. Markets were positive and investors tried to beat the ECB to bonds that now looked a little bit safer – as they did in the UK when the BoE announced its measures in the earlier banking crisis. With buying up, prices rose and the need for ECB intervention lessened slightly.

The Henderson funds rebounded, although markets are not back to normality. “Speculators and hedge funds would have had a hard time of it. There was some diversion between derivatives and physicals, but since the announcement, corporate default rates and liquidity have been largely supportive,” says Pattullo. For the time being, he says high yield is the best place to be.

Other managers have taken precautionary action in recent months. Schroder Strategic Bond fund manager, Nick Gartside says: “We increased the fund’s duration by closing our short position in 10-year gilts, locking in profits. The fund’s exposure to agency mortgage-backed securities remains stable at around 7.5%, although we expect this to fall further.”

“We have continued to rotate in terms of European exposure – we bought Bertelsmann and RCI and sold Wolters Kluwer and Accor. In the US, we have purchased some cyclical names including retailers JC Penny and Macy’s,” he adds.

He has also increased exposure to high yields, adding Daily Mail, Thomas Cook, Pernod-Ricard and ONO. Emerging markets are still popular.  Gartside has bought into Brazilian futures, expecting future rate rises.

Invesco Perpetual’s Paul Causer and Paul Read think investors should not except a repeat of the exceptional gains made in 2009.  Income will be the main driver of total returns.

“Nonetheless it remains a credit-friendly environment. Although it is possible that we will see a modest increase in short-term UK interest rates from the current emergency levels, we would be surprised if they moved significantly higher over the next couple of years,” they say.

A number of defensive blue chip equity holdings are also yielding more than their equivalent bond. They say: “In our opinion, this increases the attractiveness of the hybrid bond/equity funds that we manage.”

The equity component of the IP Monthly Income Plus fund is exposed to strong balance sheets and cash flows, which should add to dividend growth potential. The largest positions are in tobacco, pharmaceutical and utility companies. 

Q&A: Roger Webb, SWIP Investment director

Two major scares in two short years may not seem like the ideal time to launch a new Strategic Bond fund. SWIP disagrees. It complements its existing Scottish Widows Strategic Income fund run by Neil Murray with a new fund next month.

Roger Webb, investment director and co-manager of the new fund, explains why now is as good as time as any. Teamwork will be fundamental to its success.

Q. Why launch now with markets so volatile?
A. The timing is perfect for strategic bond funds.  We have seen huge inflows into the sector because of its added flexibility over pure asset classes like sovereign and high yield. There has been massive volatility and we will see more going forward.

Q. Does that make it more dangerous to launch now?
A. It is down to the ability of each manager to move from one area to another to take advantage and avoid the pitfalls of falling markets. We work on a team based approach; lead managers are backed up by others from the team. For example, Luke Hickmore [co-manager of the new fund] also runs the Sterling Credit Advantage zero duration fund.

Q. But others have not always been successful in using their Ucits powers?
A. A lot of funds in the sector are hamstrung by history, they are benchmarked or have set allocations but just happen to sit in the Sterling Strategic Bond sector. The fully flexible, more recent mandates are starting to demonstrate better results. It needs big managers with big resources to cover off investment grade, government bond and high yield.  There are a couple of two or three man teams that demonstrate the approach can work.

Adviser view: Meera Patel, Hargreaves Lansdown

Advisers like:

• Choice of funds and portfolios
• Wider Ucits powers give added flexibility
• Presently more interesting than pure corporate bond plays

Advisers dislike:

• IFA information lacking on where value added comes from
• Concerns about inflation in future

Meera Patel at Hargreaves Lansdown is emphatic about her fund selection if investors are looking for fixed income vehicles. She says: “If I were buying a bond fund now, I’d buy into strategic bonds for the added flexibility.”

She thinks the sector has been resilient, pointing to a 10% rise in values year to date for the best performers.

M&G’s Optimal Income fund is up slightly less YTD, but is a buy for its three year record.

She also likes Henderson’s Strategic Bond fund for its flexibility over the firm’s high yield and preference & bond products.

Hargreaves Lansdown also added Invesco Perpetual’s Tactical Bond fund to its Wealth 150 list at launch. “We like the IP Monthly Income Plus fund even though it has less powers,” says Patel.

Extracting information from fund providers about whether physical bond holdings or CDS, interest rate swaps or futures are adding value is a chore. Patel says managers are happy to supply information when asked, but they do not do so proactively.

“End investors might not understand it, but IFAs need this information to make an informed choice,” adds Patel.

She also warns about inflation risk. Whilst much talk still centres on deflation, governments will have to deal with QE and inflation will follow.  Investors should therefore expect more muted returns in future.