With assets of close to £36bn, the Sterling Strategic Bond sector is one of the largest peer groups in the Investment Association universe. Its appeal has been buoyed by a preference for flexible bonds funds ahead of what could be a challenging time for fixed income.
Bonds have enjoyed a three-decade bull run, supported in recent years by unprecedented monetary easing that took place in the wake of the global financial crisis. Ultra-low interest rates and massive QE programmes along with low inflation across the globe have pushed bond yields down to record lows and, in some cases, into negative territory.
Between the start of 2000 and the end of June, the Barclays Sterling Aggregate Corporate index rose by 173% in total return terms while the Barclays Sterling Gilts index was up 172%.
The FTSE All Share has made ‘just’ 88% during this time. Bonds have beaten the FTSE 100 and the FTSE Small Cap – only the FTSE 250 improved on this, with its 299% return.
While critics have been calling the end of the bond bull market for a number of years, the asset class has continued to defy the bears. Indeed, despite the occasional sell-off, yields have continued to fall.
That said, concerns about liquidity in the corporate bond market persist owing to factors such as regulatory pressure leading to lower inventories at investment banks, a growing market size and the risk of the ‘great rotation’ out of the asset class into equities.
Institutions such as the Federal Reserve, the IMF and big Wall Street banks have expressed concern about corporate bond market liquidity; Goldman Sachs even suggested a lack of liquidity could be the cause of the next financial crisis.
The demand for bonds seems to go on unabated but concerns remain about the future of this part of the market, especially as many now expect inflation to tick up from its current low levels and the US continues with monetary tightening.
With these potential headwinds in mind, we took a closer look at how funds in the IA Sterling Strategic Bond sector have held up in previous corporate bond market sell-offs.
To do this, we used three periods: between 28 August 2008 and 7 April 2009, when the Barclays Sterling Aggregate Corporate index dropped 16% in the financial crisis; 21 May 2013 to 26 June 2013, when it fell by 5.2% during the ‘taper tantrum’; and between 3 February 2015 and 26 June 2015, when the index was down 5.5% amid the turbulence that marked last year.
FE data shows that the average IA Sterling Strategic Bond fund outperformed the index in each of these sell-offs: during the first one it was down 15.7%, in the second 4.3% and in the third 1.3%.
However, a closer look at the sector suggests funds that have performed strongly over recent years might not be the ones that have held up best in difficult markets.
Thirteen of the sector’s 60 members with a long enough track record made first-quartile returns between three and five years to the end of June 2016. However, they have tended to be ones that suffered the most during sell-offs.
On average, these high-returning funds lagged behind the sector’s return in each of the three periods examined, although they did still hold up better than the index. In 2015, the average high returner was down by 3.4% – more than double the 1.3% fall recorded by its average peer.
On the other hand, there are 11 funds that are bottom-quartile for total return over three and five years and they have tended to lose less than their peers in difficult markets. Take the 2008/9 period, for example, when the average 6.5% decline was less than half that suffered by the index and the wider sector.
There are various reasons as to why some of the sector’s highest-returning funds have underperformed in down markets, but one of the major drivers is exposure to high yield bonds.
Pimco GIS Diversified Income, which is the sector’s best performer on a three-year view with a 34.4% total return and the second best after five with a 57.7%, is a good example.
This $5.7bn fund, managed by Eve Tournier and Curtis Mewbourne, currently has high yield as its largest sector exposure at 35%, positioning which has been constant for some time. The fund was the sector’s worst performer in the 2013 period and in the bottom quartile for 2015.
Other funds topping the sector for total returns but suffering in sell-offs include Chris Higham’s Aviva Investors Managed High Income, which has more than half of its portfolio in bonds rated BB or lower and was bottom quartile in the first two periods.
Royal Bank of Scotland High Yield is another obvious example of where high-yield returns led to strong longer-term performance but relatively weak numbers in more challenging markets.
Bucking the trend
Exceptions can be found, however. Eric Holt’s Royal London Sterling Extra Yield Bond, which has 45.4% of assets in high yield and another 29.2% in unrated bonds, was one of the best performers during the 2013 and 2015 sell-offs and is in the top quartile over three and five years. It must be noted that it was the worst fund during the 2008/9 period, losing close to 40% in the financial crisis.