While the term “bond funds” may not evoke the same excitement as high-flying tech stocks, they remain essential pillars of diversified portfolios. In this ever-changing financial landscape, understanding what constitutes the kind of bond fund required for optimising client outcomes remains critical.
At IBOSS, we recognise the importance of striking the right balance between risk and return. We always remain conscious of the price paid for assets, and this discipline helped us avoid the worst of the bond sale, which adversely affected many portfolios in late 2021 and during much of 2022.
The fixed income sector was one of three opportunities we highlighted in last month’s webinar, alongside emerging markets and UK equities. The opportunities and intricacies of fixed income investments can be challenging to understand, so let’s look at how we utilise them in portfolios currently.
What is a bond?
Rather than buying a share of the company like an equity holding, the investor buys a share of its debt with a bond fund. The company gains a convenient way to raise funds whilst the investor benefits from the interest rates paid to the investor.
Traditionally, bonds are considered a relatively safe way to invest; after all, there is no guarantee that a company will grow; however, a company is legally obligated to make timely payments to its debt/bondholders.
Therefore, the risk of holding a bond is the likelihood that the issuer can make the promised payments. It is worth noting that bonds can be issued by companies, governments, and even charities.
What type of bonds do IBOSS hold in portfolios?
• Strategic bonds
• Corporate bonds
• Gilts (sovereign bonds)
• Emerging market bonds
• Global bonds
What is the making of a strong bond fund in the current environment?
Identifying a strong strategic bond fund entails two key aspects. Firstly, and rather obviously, assessing long-term performance metrics offers insight into a team or manager’s track record. Secondly, evaluating performance post-Fed Chair Powell’s inflation acknowledgement in November 2021 is crucial. This was the start of the grand reset in bonds, and the world of bonds has looked different ever since.
Long-term numbers, such as the Sharpe ratio, indicate managerial efficacy over time. Meanwhile, recent data reveals how managers navigated shifting market sentiments, particularly concerning inflation, arguably the most critical factor of the last forty years. The best-performing funds avoided complacency regarding perpetually low-interest rates, adjusting portfolios to include high-yielding, short-duration assets. This proactive stance, despite career risks, distinguishes some bond funds against their peers.
Central Bank Missteps
It’s crucial to discern the distinct factors affecting sovereign bonds, distinguishing between idiosyncratic influences and broader regional and global trends. As we navigated through Q4 of 2023, it became apparent that the world had likely peaked in inflation or at least reached a temporary plateau. This shift alleviated pressure on central banks like the Fed, ECB, and BoE, relieving them of the need for continued rate hikes.
The struggle central banks face in managing rate policies isn’t surprising given their collective oversight of inflation signals. In 2020/21, while many corporations sensed mounting pressure on prices and escalating employee demands, central bank leaders – Powell, Lagarde, and Bailey failed to heed these warning signs.
This prolonged failure bears significance, exacerbating the eventual impact on bond prices. For instance, the yield on the US 10-year treasury surged from around 0.5% in July 2020 to a peak of 5% in October of last year.
How do the different types of bond funds differ in terms of objectives?
When it comes to a fund’s objective, we spend our time looking at the results and where historically a fund has invested rather than looking at how a fund is supposed to behave according to a factsheet or prospectus. For example, many funds in the sector say they can invest equities alongside bonds in their fund objective. The vast majority don’t appear to do so.
When the positive correlation between bonds and equity investments is low or even negative, an equity allocation is often a significant contributor to the difference in results, whether positive or negative.
The risk of a bond is impacted by how likely it is that an issuer of the bond can make the promised payments. There are two factors to consider:
- The first is the trustworthiness of the issuer. For example, it is much more unlikely that the UK government would default on its payments than, for example, Argentina, which has defaulted on its debt nine times.
- The second is how long the issuer wants to take the loan out. The longer the term, the more payments will have to be made, and the more things that could go wrong between now and the end of the bond term.
Considering these points, developed market sovereign bonds are considered lower risk than developing market bonds, and bonds issued by large, well-known companies are generally considered lower risk than small up-and-coming businesses.
It is worth mentioning that the higher the perceived risk of the issuer, the higher the rate on the bond, i.e., investors require additional payment to take on the associated risks.
What are the potential benefits of using a strategic bond fund, and are there any drawbacks?
The benefits of the strategic bond sector are that the manager has maximum latitude to use duration, credit quality and, in some cases, equities to add alpha for their investors. They can utilise currency and derivatives to add value or control risk to varying degrees. The flip side is that all these potential benefits can destroy value if the manager makes the wrong calls. It is primarily for this reason we use multiple managers within our strategic bond holdings. Using multiple funds limits the potential for an extremely bad call that would unduly affect a portfolio’s performance overall while maintaining a strong degree of upside potential.
In a nutshell, you give the strategic manager the ability to use a more extensive toolbox than just using more mainstream corporate or sovereign bonds, which can include limited exposure to emerging market debt.
How much space does IBOSS allocate to bond funds in a portfolio – and why?
Our medium-risk portfolio allocates around 28% across a range of various fixed income assets.
15% of this is allocated to strategic bonds and corporate bonds. It’s fair to say that many strategic bond managers coalesce around similar average credit qualities and duration, a point witnessed through 2022. The active bond manager positions sit alongside a mainly passive allocation to sovereign bonds. These passive allocations give us confidence in the approximate duration for the fixed income allocation within the portfolio overall.
At the beginning of last year, we decided to allocate to an emerging market debt fund as it is an area in which most other bond sectors either cannot or do not invest. This addition adds an asset class that often has a low correlation to other bond holdings in the portfolio and totals an average position of 3% across portfolios.
What about 2024 makes the opportunity for fixed income more attractive than in previous years?
In the wake of the bond market turbulence since mid-2020, retail clients and professionals have felt the sting, especially if they heeded the assurances of central bank governors. However, the landscape has shifted, and sovereign bonds present a more attractive risk/reward proposition than in years. Despite the psychological hurdle of rationalising past losses, it’s essential to recalibrate portfolios strategically, adjusting allocations across fixed income, equity, and cash sectors in response to the current market dynamics.
Strategically, diversifying away from traditional sovereign bonds towards emerging market debt, shorter-dated bonds, and high yield helped protect valuations in the bond rout of 2022, but now it looks very different. Using hindsight suggests avoiding bonds altogether, but the price you pay for any asset is important, and the starting price on many bonds looks cheaper than it has for many years.
Our optimism towards the broader bond market has grown, except for areas of the high-yield market where the risk-reward balance doesn’t quite justify explicit exposure. Bond investments hold promise for investors seeking growth, income, or a blend of both. This positive outlook extends in absolute value terms and relative to cash, as well as some equities over the medium term.
This communication is designed for informational purposes only and is not intended as investment advice. These investments are not suitable for everyone, and you should obtain expert advice from a professional financial adviser. Please note that the content is based on the author’s opinion at the time of writing/publish date. Our views and opinions regarding certain investment themes and topics can alter over time as the macroeconomic background changes and other industry news is made publicly available, this is not intended as investment advice.
Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise, and investors may get back less than they invested.
IBOSS Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Financial Services Register Number 697866.
IBOSS Asset Management Limited is owned by Kingswood Holdings Limited, an AIM Listed company incorporated in Guernsey (registered number: 42316).
Registered Office: 2 Sceptre House, Hornbeam Square North, Harrogate, HG2 8PB. Registered in England No: 6427223.
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