Bond exchange-traded funds may have been capturing an increasing share of the market but this year, says Darius McDermott, there are three good reasons why investors might prefer to steer clear of bond trackers
When bond managers are telling you there is a reasonable chance you will lose money if you invest in the bond index in 2017, it is a pretty clear sign the bull market of 30-plus years is coming to an end. Rising interest rates and inflation were always going to spell trouble for the asset class, but various global events have kept these catalysts at bay for longer than many expected.
This year, however, the outlook appears to be changing. Central bank policies around the world will diverge yet, overall, we may finally be at the beginning of a new cycle. Monetary policy in certain regions - notably the European Union - may mask the signs, but there are indicators we cannot ignore.
To offer one example, HSBC abandoned its 0.99% two-year mortgage deal in the UK at the end of last year - having only introduced it in June - possibly because the bank could no longer fund it looking at future cash rate projections.
We talk a lot in our industry about active versus passive management when it comes to equity funds, but bond funds have traditionally been less of focus. Yet last year, bond exchange-traded funds captured an increasing share of the market. In 2017, however, I can think of three very good reasons why you do not want to own a bond tracker.
1. Avoid long duration bonds
Long duration bonds are not where you want to be in this environment and passive funds tracking the index are much more likely to have longer duration and, therefore, heightened volatility. We have started to see this already with the ‘Trump effect ‘and we can expect more of the same when ECB president Mario Draghi does begin to taper.
An active, strategic bond fund manager can shorten the duration of their portfolio while the yield curve rises. Or you can choose a fund like the AXA Sterling Credit Short Duration Bond, which typically invests in high-quality corporate bonds with maturities of less than five years.
2. Outpace inflation
Active managers can also move higher up the yield spectrum to try and outpace inflation. An excellent example of strategic duration and yield management is the MI TwentyFour Dynamic Bond fund, whose gross purchase yield is 5.12%, with an average duration of three years (as of 31 December 2016). By way of comparison, the iBoxx Sterling Non-Gilt index has a yield of just 2.45% and a duration of 8.2 years.
To enhance yield, the Dynamic Bond fund will go into some of the riskier or ‘less standard' areas of the market, such as European collateralised loan obligations (CLOs) and subordinated financials, but the team at TwentyFour are among the few in the industry I would trust to navigate these waters. Subordinated banking debt has indeed historically been the fund's best contributor to performance. Another strategic bond fund I particularly like is GAM Star Credit Opportunities.
3. Be selective with credit risk
As interest rates rise, so too does credit risk, which further emphasises the need to be selective - especially in the high yield space. With risk spreads so low for so long, all sorts of issuers have come to market who probably should not have. In owning a bond tracker, you automatically have exposure to this debt.
Another important point to bear in mind is that, by investing in a passive bond fund, you are also most heavily weighted to the most indebted countries or companies. Is this really where your clients want to be? Again, probably not. Within the high yield space, for a fund with a track record of strong stockpicking, I like Baillie Gifford High Yield Bond.
Darius McDermott is managing director of Chelsea Financial Services
Retired in 2014
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