If interest rates do rise, fund managers shifting duration positions in strategic bond funds could come up trumps, writes Morningstar OBSR investment research analyst Marianne Weller...
Following the US Federal Reserve’s comment in May that bond purchases could slow down by the end of the year given the improving macroeconomic situation in the US, fixed income markets have seen considerable volatility over recent months.
Government bonds were directly impacted, with yields rising. Bond markets across the fixed income spectrum experienced outflows.
Between 22 May and 16 October, the 10-year UK treasury yield rose from 1.9% to 2.8%. Investment grade corporate bonds, which have longer duration profiles and relatively low yields, also performed poorly, especially in June.
Their correlation to government bonds has increased in recent years considering the search for yield and unconventional monetary policies has pushed spreads lower. High yield bonds have fared better as the asset class’ short duration characteristics mean it is less sensitive to a rise in interest rates.
While bond markets steadied to a certain extent during the third quarter, the consensus view is for bond yields to rise gradually, even though interest rate rises may be a long way off in the US.
In addition, other major economies, such as the UK and Europe, are still in a fragile state. The Bank of England and European Central Bank have not altered their stance and continue to maintain an accommodative monetary policy.
Indeed, a number of managers we talk to have highlighted the fact it has been hard to call the direction of government yields and bond prices this year, and expect markets to remain volatile.
Against this backdrop, investors are, unsurprisingly, concerned about their allocation to fixed income. In this environment, a more flexible approach to fixed income investing may be needed and strategic bond funds could have an increasingly important role to play in a portfolio.
The Strategic Bond sector only came into existence in 2008, growing out of the Other Bond category. The sector’s definition is very loose, with the only requirement being that “funds must invest at least 80% of their assets in sterling denominated (or hedged back to sterling) fixed income securities”.
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