The downside of adopting a passive strategy in other areas, notably the corporate bond sector, is that bonds tend to be selected on the merits of liquidity. In the long term, I believe this could lead to underperformance as investors have unwittingly bid up prices, increasing volatility in the process. An active strategy allows the potential for superior long-term returns, dependent on the skill of the manager and his research team. Timing and stock selection are key.
However, in the strategic bond sector, where the benchmark is essentially unconstrained, there is a wider dispersion in returns of individual funds both on the upside and downside where managers underperform. As a result, due diligence on fund managers and their investment houses is crucial. I recommend investors scrutinise the long-term record of funds, especially in relation to risk and return, the credentials of the fund managers, including the length of tenure in their current role, and achieve a clear understanding of each fund’s strategy and how it would fit in their portfolios before investing.
Having considered the theory, how do these funds stack up in practice? The table shows the long-term performance of the different Investment Association bond sectors over the past 20 years to the end of April 2017.
| Annualised Performance (%) | Annualised Volatility (%) | Sharpe Ratio* |
IA UK Index Linked Gilts | 7.4 | 7.6 | 0.7 |
IA UK Gilts | 3.7 | 6.1 | 0.3 |
IA Sterling High Yield | 3.5 | 7.4 | 0.2 |
IA Sterling Corporate Bond | 2.7 | 5.1 | 0.1 |
IA Sterling Strategic Bond | 2.3 | 4.8 | 0.1 |
Source: FE Analytics
Note: *Assuming a long-term risk-free rate of 2 per cent
At first glance, the strategic bond sector has performed poorly against other fixed income sectors. Not only has it achieved the lowest annualised returns at just 2.3 per cent, but risk-adjusted performance, as measured by the Sharpe Ratio, has been the worst too, arguably suggesting the risk is not worth the reward.
Returns have also lagged over the one, three, five and 10-year periods. However, over these timeframes volatility has consistently been the lowest, resulting in an improved Sharpe Ratio, favourable to other sectors. One should also bear in mind that returns over 20 years do not accurately reflect the current constituents of the index because of the sector's rapid growth during that time.
Despite these caveats, the undeniable conclusion is that strategic bond funds as a whole offer a generally cautious approach to fixed income investment. I would suggest this is due to the use of derivatives; credit default swaps and bond futures are widely used to limit downside risk. Given that we have been, and arguably remain, in a long-term bond bull market, it is clear to see why the sector has underperformed. Gains made by the underlying bonds have been offset by losses from derivatives. The sector is therefore suitable for investors who are considering lower risk exposure to the sector, but still require income.
