How to negotiate the Strategic Bond sector

Fidelity International multi-manager Eugene Philalithis examines why the Strategic Bond sector remains a popular choice for investors.

Strategic bond funds remain popular. The IMA’s Sterling Strategic Bond sector was the best-selling sector for the second month in a row in March, with total net retail sales of £337m.

In the current environment of heightened uncertainty about inflation and the direction of interest rates, the popularity of the sector should not be surprising because in many ways it is tailor-made for such conditions. However, investors should also be aware of the scope for significant differences among the various funds within the sector and be sure they understand the implications of these differences.

A N Other

In existence since only 2008, the Sterling Strategic Bond fund sector is relatively new. It grew out of the “other” bond fund category which was the home of any fund that could not be categorised according to the other sector classifications.

Perhaps unsurprisingly then, the Strategic Bond sector’s own definition is remarkably loose, certainly when compared to all the other major bond classifications. The only major requirement of the sector is that funds must invest at least 80% of their assets in sterling-denominated (or hedged back into sterling) fixed income securities. Importantly, the sector has no restrictions regarding credit quality.

The lack of strict criteria means funds within the sector can benefit from a potentially high degree of strategic flexibility. In particular, managers have the ability to invest right across the credit spectrum from investment grade to high yield. In addition, they can also invest in non-bond fixed interest investments (such as preference shares), anywhere in the world (as long as the currency exposure is hedged).

In theory, this offers investors the possibility of investing in a single ‘all weather’ type of fund that can take care of the whole of their bond allocation, with managers empowered to adjust weightings in accordance with prevailing market developments and economic themes. Another oft-cited benefit of the strategic bond sector is the wide opportunity set of viable investments, which in theory allows for more places in which to look for alpha.

A number of funds in the sector have done a very good job of taking advantage of the large opportunity set and investment flexibility that is available to them. For example, the managers of those funds that recognised that sentiment had become excessively bombed-out following the collapse of Lehman Brothers in 2008, and who were brave enough to increase their credit risk exposure selectively around this time, were rewarded very handsomely.

An uncertain environment

Today, the environment for bond investing is once again rather challenging, with an unusual degree of divergence in policy rates across the world and uncertainty about inflation.

The UK perhaps typifies this uncertainty better than anywhere else, with the current three-way split within the Bank of England about the direction of UK base rates. These differences revolve in large part around the threat posed by inflation, with some in the Monetary Policy Committee advocating an immediate increase in the base rate.

A few fund managers within the Strategic Bond sector evidently share these concerns because they have been modestly increasing their weightings to inflation-linked bonds.

Uncertainty also stems from the possible adverse impact of the end of the US Federal Reserve’s asset buying programme, dubbed QE2, with some notable fund managers such as Bill Gross expressing concerns about what this could mean. Closer to home, we have the ongoing eurozone sovereign debt crisis, which seemingly never leaves the headlines.

Amid all these uncertainties, investors should ask themselves whether they have the time, inclination and the capability to make the right kinds of allocation decisions. If they are not certain about this, then perhaps it is better to leave this to the professionals; a high quality Strategic Bond fund with a good track record could therefore represent a very good total bond solution for some.