Six-strong Fixed interest team led by Andrew Sutherland relies on good communication to maintain fund performance
Standard Life Investments is well known for its range of fixed interest funds, which have achieved consistently strong performance since launch. The flagship in its range is the £345m AA-rated Standard Life Corporate Bond fund, which yields around 5%.
The fund is ranked 14 out of 60 in the UK Corporate Bond sector over three years to 19 May, returning 22.4%, offer to bid, compared to the peer group average of 19%.
Also in the Standard Life range is the £191m A-rated AAA Income fund, which yields around 3.5%. This is ranked sixth in the sector over the same period, returning 24.9% offer to bid.
Standard Life also offers a Higher Income fund targeting an 8% yield. This A-rated fund can have up to 60% of its portfolio in high-yielding debt.
To complete the range on offer, in April the group launched its Select Income fund with a target yield of 6.5%-7%, net of charges. This has since been reduced to 6%. The fund is able to hold up to 20% of its portfolio in sub-investment grade bonds, at the manager's discretion.
Corporate bond funds are managed by a team of six based in Edinburgh and headed by Andrew Sutherland.
How is the team organised?
Each of the six fund managers in our team also has an analyst role. We each look at a different sector and then put our ideas together at weekly meetings.
How does your investment process work?
We start at the top level by looking at three main drivers. These are interest rate swaps, credit outlook and supply and demand for corporate bonds.
These factors determine how aggressive we want to be in our credit exposure ' whether we want to hold gilts, if spreads are too tight, or how far down the credit spectrum we want to go.
We use our own model to look at interest rate swaps and this gives a clear estimate of where they should be. We include forecasts from the gilt team to determine where we think swap spreads are going in three, six and 12 months' time. This gives a good indication of where corporate bond spreads are going.
Right now, swap spreads have come in a long way. We are still expecting a bit more tightening to come through, the main influence being the pick-up in government issuance and steady, low interest rates.
We also look at supply and demand. Before the war, supply was slightly above average compared to previous years. We hit a lull during the war but since then it has started to pick up again.
However, it is still not outstripping demand. In a low-yield environment, people are having to take on credit risk to get income. That remains a positive for corporate bonds ' there are still life companies, pension funds and so on looking to increase their exposure to credit.
What about credit background?
We look at trends in defaults and rating agency decisions. It seems we are past the worst for defaults, and ratings actions are becoming slightly more balanced.
We also look at companies to see what they have been doing recently. In general, they are cutting back on capital expenditure in a bid to survive. This is obviously good for credit ' they remain constrained by their newfound desire to maintain credit ratings. Running up more debt would not help that.
What is your view on each area of the market?
Overall, we are cautious about the levels of gilts but further out we are looking for a continuation of the recent trading range, provided inflation remains stable.
On corporate bonds, we are looking for spreads to come in, albeit not as much as they have done, but there is still a lot of demand out there for them. We think there is more potential for lower-rated bonds to outperform from here.
Within high-yield, we anticipate continued support from the low interest rate environment and steady but low growth. They have been strong and have bounced back from last year's oversold level to fair value.
Once you have determined where you want to focus, what happens next?
The next step down is that we look at sectors to determine where we are positive. Emphasis on certain sectors will then be allocated to funds, according to individual benchmarks and risk requirements.
What sectors are you focusing on and avoiding currently?
We are heavy in financials and telecoms at the moment. Meanwhile, we are light on the AAA sector and some of the industrials.
The reason we like financials is that you avoid a lot of the potential negative event risk you get with some of the industrials. These are prone to, for instance, leveraged buyouts. Safeway is a good example of this.
You get other problems with, for example, pension deficits. So, while the whole market is strong, we think there will be a time when investors will become more selective in credit. There is a chance the market will go back to the two-tier conditions of late 2002.
We are reasonably happy with financials against that background and feel they look reasonably safe.
Telecom companies look attractive due to their improving credit outlook. The large national operators are national assets and governments would support them ultimately.
What are the features of the Standard Life Corporate Bond fund?
The fund has to hold bonds that are BBB-rated or above. Currently, the average rating is probably closer to A. Around 25% of the fund is in BBB names.
Credit ratings do not drive our credit selection process; sector selection is the primary focus. The rating profile of any fund really just reflects the sectoral weighting.
Average duration is about 7.5 years and this level has been maintained for some time. The portfolio has about 75 stocks.
Another feature of the fund is that 10%-15% of it is held in debentures. It is a growing fund and there is no problem holding a small amount in something illiquid. Debentures are asset-backed and have good recovery potential.
As a long-term core holding, we are essentially being paid for the illiquidity rather than taking any significant risks.
How actively traded is the portfolio?
It is not high. Turnover is about 250% a year.
How have you steered your fund through the recent tough economic times that led to a high number of defaults?
The key thing over the past 12 months has been avoiding disasters. The interesting thing is the fund did actually have some WorldCom, a holding of about 1.5%.
The WorldCom experience gave us the extra insight into the fact things could go wrong. This made us reassess the way we manage money. As a result, we developed a tool we call a credit matrix, which is essentially a scoring system for corporates.
This credit matrix gets inputs from a number of areas including our equity team, our corporate governance team and rating agencies. It looks at things like whether a company is aggressive in acquisitions, for example.
An important element of this is that we have our team of six linking in with the equity team. It is very much a two-way conversation. Because equities have been the way they have for the past few years, there is a lot of focus on debt levels and survivability. We are therefore talking the same language.
Do you hold gilts in the corporate bond fund?
From time to time we do. We can hold up to 25% in gilts but we do not hold any at present.
It goes back to the three drivers at the top of the process: the spread model, the credit outlook and the supply and demand. That dictates what exposure to gilts is going to be in the fund. We would go into gilts if we thought credit spreads were too tight.
Can you give an example of a corporate bond you have been buying recently?
An issue we like is the sterling bond of Banco Santander. In UK financials, we have been quite cautious. We have been following companies with strong UK domestic retail banking franchises such as Royal Bank or HBOS.
Banco Santander does have a very strong Iberian retail franchise but there is Latin American content as well. We weren't very positive until early this year because of this but our emerging markets equities team became very positive on Brazil and Latin America. This enabled us to take a more relaxed view so we now hold the company across our funds.
How does the new Select Income fund work?
It is managed in a similar way to the Corporate Bond portfolio, on BBB and A issues rather than further up the credit scale.
Instead of the 15% debentures, we have up to 20% in high-yield, so there is a minimum of 80% investment grade in the fund. That will be comprised of financials, telecoms, utilities, structured bonds and emerging market debt.
At the moment we are at our maximum exposure to high yield because we think it is an attractive area of the market.
FUND MANAGER: Andrew Sutherland
Sutherland joined Standard Life as a graduate trainee in 1980 after gaining a degree in mathematics and music at Glasgow University.
He has been managing funds since 1988 and was appointed investment director with the launch of Standard Life Investments.
Sutherland is now the manager of SLI's fixed interest department, which offers a broad range of products.
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