Licensed to thrill – investors flock to strategic bond funds

25th August 2010

Since the fourth quarter of 2009, investors have been investing heavily in sterling strategic bond funds.

Corporate bond funds have traditionally been thought of as a source of safe, steady returns. This made them an ideal diversifier for an otherwise equity-based portfolio. Unfortunately the credit crunch taught investors that there is a lot more to this sector than they may have first thought.

The impact of the credit crisis

From February 2008 to April 2009 the IMA sterling corporate bond sector fell almost 15%. Many of the individual funds fared much worse.

"As the European economy went into recession, European corporate bond defaults rose sharply from an annual rate of 0.68% to 11.57%," explains Sarang Kulkarni, Fund Manager – European Credit, at Schroder Investment Management.

"This made investors risk averse and they sold corporate bonds in order to buy more secure investments such as government bonds or cash."

In the last quarter of 2008 European nominal GDP fell 2.7% from the third quarter and collapsed again by 4.4% in the first quarter of 2009. With the banking sector in turmoil this left companies battling falling demand and tighter financing.

Marcus Pakenham, Equity and Fixed Income Product Specialist at HSBC Global Asset Management, says that bond investors needed a higher rate of interest to compensate for the higher risk.

"Between the end of the third quarter of 2008 and the end of the first quarter of 2009, lower investment grade BBB corporate bond yields rose from 8.7% to 12.1%."

The subsequent recovery

Governments around the world were forced to intervene, cutting base rates and initiating various programs of quantitative easing and fiscal stimulus.

"Sterling corporate bonds yields were very attractive relative to gilt yields and as the economy improved, investors started to switch from gilts and cash into corporate bonds," notes Kulkarni.

The corporate sector's response to the lack of liquidity was to cut costs and the result has been an extraordinary growth in profits and cash flows.

Pakenham says that this has allowed many companies to reduce debt levels and lower leverage. "The combination of rising cash flow and falling leverage has been positive for bond holders and yields have fallen."

Sterling corporate bonds have now made up all the lost ground and are back in positive territory.

Investors switch to sterling strategic bond funds

In spite of this strong recovery investors have been consistently taking money out of sterling corporate bond funds since the fourth quarter of 2009. Instead of coroprate bonds many investors have favoured strategic bonds.

Martin Bamford, MD of IFA Informed Choice Ltd, says that there has been a fear recently that gilts will perform poorly and they are often closely correlated with investment grade corporate bonds.

"This has prompted advisers and investors to look towards the strategic bond sector in a bid to give the fund manager some flexibility to move at least part of the portfolio into higher yielding bonds."

The main difference between the two sectors is that sterling strategic bond funds have no restrictions on the credit quality of their holdings, whereas the corporate bond equivalents can only invest in investment grade bonds.

Bamford says that strategic bond funds allow investors to be less proactive when it comes to timing the credit cycle, as these decisions can be left to the fund manager.

"The fund mandate places a restriction on the manager, which enables the investor to be comfortable about the maximum level of risk that can be taken, but does not constrain the manager to such an extent that they are unable to make important judgement calls."

He sees the sterling corporate bond sector forming a core position in investors' portfolios, but suggests there should also be some allocation to the strategic corporate bond sector.

The average yield for investment grade sterling corporate bonds is currently around 5%, whereas the figure for the high yield equivalents is more like 9.5%.

"In an environment of falling default rates we find this additional yield attractive, as over time it can deliver stronger returns," concludes Kulkarni.

The performance data from the Sterling UK Corporate Bond and the Sterling Strategic Bond sectors are both available on Trustnet.


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