Have strategic bond funds done their job?

Since the start of the year, returns on most fixed income assets have been the worst in most investors’ memories. Even ‘safe’ assets like US and UK government bonds have seen their value plummet.

Why? Because a combination of inflationary pressures and central banks raising rates is a perfect storm for fixed income. 

But it’s just this type of fast changing environment in which strategic bond funds are supposed to come into their own. Their flexibility and agility should enable managers to move between fixed income asset classes to make the most of opportunities and minimise the risks.

Have they done their job?

In an environment of high inflation and rising interest rates – such as the one we are in now – there is no hiding place.

When central banks raise interest rates, the yields on government bonds increase too. But this pushes down the price of the bond, which means existing investors lose money. This then has a knock-on effect on corporate bonds which need to have even higher yields than government bonds to compensate investors for the extra risk they are taking loaning them money.

According to the Jupiter Strategic Bond team this has resulted global government bonds falling around 8% since the start of the year. High quality corporate bonds did not perform any better, with losses around -12%, while more growth-sensitive risk assets such as high yield or emerging market bonds, are down anywhere between -15% and –20%.

But on aggregate, Strategic Bond funds have indeed done their job. Their diversification means that the average fund in this sector has performed better than the average fund in the Corporate Bond, High Yield bond, UK Gilt and UK Inflation-linked Gilt sectors*.

No, don’t get me wrong, these funds have still lost money in the market carnage, but the losses have, on average, been less.

What strategic bond fund managers have been doing

An example of this flexibility in practice comes from the Aegon Strategic Bond fund. Co-manager Colin Finlayson told me that, during June, he allocated more to the high yield market which is less interest rate sensitive. And, because he has no requirement to have any weight in a particular country or sector, he has been using the fund’s flexibility to identify the best opportunities across the UK, US, Europe or beyond. “Year-to-date the focus has also been on trying to mitigate many of the risks that we are facing through higher interest rates and the rising yield environment,” he said.

The Jupiter Strategic Bond fund team has added to some government bonds. “One point that it is important to underline to our investors is that the current yield in government bonds reflects not only the base rate hikes that have already happened, but also the base rate hikes that the market expects to happen,” it said. “A further seven rate hikes – that’s an increase of 1.75% from today – is baked into the current yield of US government bonds. If, as we strongly believe, the Federal Reserve is unable to achieve those hikes, the yield on those bonds will fall, and our strategy will benefit.”

The team is also finding interesting opportunities in the high yield market, especially in Europe. “As the sharp slowdown in the global economy is more reflected in credit markets, we expect to add to bonds we think will survive a downturn at still more compelling valuations,” it said.

The other type of bond fund that has fared better in 2022 is those that have the ability to be short rates, like Jupiter Strategic Absolute Return Bond [IE00BF1F1K54]. “Our strategy has this flexibility and for the majority of the first half of this year we have been net short of duration allowing the fund to deliver a positive performance year to date and also to significantly diversify versus the outcome for many traditional fixed income funds, but also from other absolute return funds,” said manager Mark Nash. “As well as being short duration for the majority of this year we have also been net short of credit.”

But what of the future?

According to Colin Finlayson, while the macroeconomic backdrop is still pivoting on the outlook for inflation, the market is becoming increasingly sensitive to signs of slowing growth and the rising probability of a recession. “Volatility will remain elevated in the coming period and inflation, as ever, will be key in driving markets,” he said. “As we anticipate that we are nearing the peak of the inflation cycle, current valuations make this an attractive time to add fixed income risk to your portfolio.”

Mark Nash added, “The second half of this year should see some easing of inflationary pressures as the base effects work their way out of the system. This should allow bond markets to take out some of the extremes of the rate hike profile currently priced in to markets and also allow risk markets to perform better.”

Nick Hayes, head of total return & fixed income asset allocation at AXA Investment Managers agrees. “Received wisdom is that a climate of rising inflation and higher interest rates is bad news for the fixed income market. However, if markets have already adjusted to an environment of higher inflation, this is not necessarily the case. With higher government bond yields have come wider credit spreads, extending the opportunities in corporate bonds. Yields for investment grade credit markets in both the US and Europe are now higher today than their respective 10-year averages. This should be a signal for investors.”

Income once again an option

“Fixed income has been unloved, with many global asset allocators shying away from an asset class that appeared to offer plenty of risk and little potential reward,” continued Nick. “With yields higher, buyers may tentatively return, certainly if inflation appears to be nearing its peak. Fixed income is now in play again, in stark contrast to the TINA (There Is No Alternative – to equities) view of the last few years.”

Capital Group agrees. “Over time, higher rates will also bring income back to the fixed income markets — something that has been sorely missed in the era of easy money,” the company said. “The importance of that shift cannot be overstated. It should eventually restore bonds to their rightful role providing diversification from equity risk.

“The income opportunity in bonds is also the brightest it has been in years. Going forward, investors now have the potential to earn significantly more income from bonds. In fact, a greater portion of investors’ income needs could potentially be met with traditional fixed income than would have been the case in recent years.”

Investors wanting to increase their exposure to strategic bond funds could consider the likes of Baillie Gifford Strategic Bond, Janus Henderson Strategic Bond, Jupiter Strategic Bond, Nomura Global Dynamic Bond or TwentyFour Dynamic Bond, which are all on the Chelsea Core Selection.

*Source: FE fundinfo, total returns in sterling, 31 December 2021 to 14 July 2022

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius' views are his own and do not constitute financial advice.