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Why it's good to be selective: Strategic bonds

Not all fixed income markets behave in the same way and the performance between them differs significantly. Actively allocating between them helps to add value and avoid loss.

Risk Warning: The value of investments and the income from them can go down as well as up and your clients may get back less than the amount invested.

Different types of bonds perform in different ways during different phases of the economic cycle. This means the bond market is replete with possibilities: there are investment choices to fit all types of situations.

What drives performance? The four key drivers are: flow of money; direction of price of money (i.e. yield); opportunity costs; and default risk. At different times in the economic cycle, different drivers will be in the ascendancy. An investment in any part of the bond universe will be affected to a greater or lesser extent by these key drivers.

Typically, bond funds are constrained by the requirement to invest in a very small or explicit universe. For example, their remit might be to invest in investment grade corporate bonds only. This can leave investors exposed to significant degrees of market risk.

The table below indicates the sometimes extreme fluctuations in the sub-asset classes of fixed income over recent years.

Chart: Extreme fluctuations in the sub asset classes of fixed income over recent years

However, this is a risk that can be mitigated. While typical bond funds are vulnerable to the vagaries of the market, strategic bond funds – which have a much wider remit, and can invest among a wide range of sub-asset classes – are well positioned to take advantage of these variations in asset class performance.

One of the problems with the sector is its amorphous nature. Some ‘strategic’ funds are quite focused and specific. Others have a global remit, while yet others focus on the UK and Europe. Rather than reducing risk through diversification, some funds have substantial high yield exposure.

With strategic bond funds, you need to look carefully at the ingredients

To avoid adding exposure unintentionally, investors may consider it prudent to choose a strategic bond with a pure fixed income opportunity set. The Aberdeen Strategic Bond Fund is one such fund – a fixed income fund that is diversified and flexible in its approach. It has the ability to invest across the bond universe, free from any benchmark or asset-class restrictions. This means investors can benefit from opportunities that arise in any of the world’s fixed income markets. At the same time, it is possible to minimise the downside risks associated with committing to any single sub-asset class within the fixed-income sector. If we have a strong view on credit or interest rates, we have the tools to fully reflect those views. In essence, we make the asset allocation decisions, meaning that clients should be exposed to the right markets at the right time.

Many funds within the sector have a narrow remit, restricting flexibility. Yet ideally, a fund’s prospectus should allow it a sufficiently broad remit to use derivatives to facilitate low-cost moves and asset allocation shifts, and to offset the negative impact of rising yields on capital values. Derivatives can be used to minimise volatility, help maximise returns and rebalance asset allocation cost-effectively.

As with so many things in life, size does matter. Clearly, a fund that can draw upon the resources of a large fixed income team and a global reach will have competitive advantages – such as access to the best new issues and platinum status among counterparties. Our team at Aberdeen takes a fundamental approach – down to the level of individual bond issues – that is continuous, ensuring that opportunities can be identified as they develop. We have access to a deep resource of analysts and portfolio managers across the globe covering an array of fixed income markets.

Thus, managers can formulate their overall fund strategy, facilitating analysis of relative value between different asset classes at different stages of the cycle. We focus significant attention on identifying and exploiting the most relevant themes which we believe are likely to drive financial markets. These themes are rarely confined to individual asset classes with geographic exposure and industry sectors often being of greater importance when investigating the optimal way to exploit the themes.

The lack of a benchmark constraint allows a strategic bond fund manager to take advantage of performance-enhancing trades as well as risk-reduction opportunities. Such a fund can potentially avoid the dangers faced by single asset class funds, each of which are likely to fall out of favour with investors at some point in the business cycle.

How does a big-picture thematic approach translate into everyday investment decisions? The themes can and do affect asset allocation decisions. Take the Eurozone sovereign debt crisis – a huge cross-asset theme. For some time it was a driver of duration choice, in that the ‘flight to safety’ during stress points tends to lead to a desire for longer duration in ‘safer’ markets like the UK and Germany. The crisis was also a driver of exposure to default risk. The risk that a country might exit the Eurozone will lead to an underweight position in both sovereign and corporate debt in that country. And thirdly, it is a driver of volatility risk, in that the crisis has lowered investors’ overall risk-taking appetite.

We remain positive on prospects for the financial sector, and banking in particular. Following the global financial crisis, we understand people’s concerns regarding this sector, and we believe a pragmatic approach is still appropriate. However, we recognise that the sector has undergone significant change over the past few years to address many of the fears.

Banks in many jurisdictions, driven largely by regulatory pressure, have refocused their activities, sold non-core assets and significantly improved their capital positions. Banks in the UK in particular are worth highlighting, having materially improved over the past few years.

Another theme which affects all our markets to differing degrees is the supply and demand backdrop. Easy central bank policy in the form of low interest rates and balance sheet expansion has been a significant driving force since the onset of the financial crisis. There is also material structural demand for fixed income assets as a result of changing demographics in the developed world and the ongoing hunt for yield.

This dynamic – together with levels of supply which are failing to keep pace – means we continue to favour credit risk over government bonds and investment grade over high yield, for the time being at least. We also believe that yield curves are likely to flatten.

A pure strategic bond fund is unlikely to have an index benchmark. It is likely to be able to asset-allocate across the whole of the bond universe. It should have access to the skill sets to be able to manage across all government bond markets, across emerging markets and into investment grade and high yield globally. By so doing, a strategic bond fund looks to generate the best possible returns for all its clients.

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Why it's good to be selective: Strategic bonds

Important Information
For professional investors and financial advisers only – not for use by retail investors

The following risk factors should be carefully considered before making an investment decision:

  • The value of investments and the income from them can go down as well as up and your clients may get back less than the amount invested. Past performance is not a guide to future performance.
  • Fluctuations in interest rates are likely to affect the value of the bonds and other fixed-interest securities held by the Fund. If longterm interest rates rise, the value of your clients' investment is likely to fall.
  • There is a risk that the issuers of bonds may not be able to repay the money they have borrowed nor make any interest payments. This risk is greater than average where the Fund invests in a bond with a below investment grade credit rating.
  • The Fund may have holdings which are denominated in different currencies and may be affected by movements in exchange rates. Consequently, the value of the Fund's investment may rise or fall in line with exchange rates. This may also cause the value of any income generated to go up or down.
  • Derivatives will be used to a significant extent in this Fund. Whilst derivatives will be used for this Fund to reduce volatility this cannot be guaranteed and using derivatives may at times lead to increased price volatility. Therefore investors should be prepared to accept the risks associated with these investments and be aware that their capital is not guaranteed.
  • Further details of the risks relating to investment in this Fund can be found in the Prospectus, which is available on request or at our website aberdeen-asset.com

Contact us
For more information please contact our Sales Support Team, visit our website at purebredbondfund.co.uk or call 0845 485 3017

OTHER IMPORTANT INFORMATION
The Fund is a sub-fund of Aberdeen Investment Funds ICVC III, an authorised open-ended investment company (OEIC). The Authorised Corporate Director is Aberdeen Asset Fund Management Limited. Nothing herein constitutes investment, legal, tax or other advice and is not to be relied upon in making an investment or other decision. No recommendation is made, positive or otherwise, regarding individual securities mentioned. This is not an invitation to subscribe for shares in the Fund and is by way of information only. Subscriptions will only be received and shares issued on the basis of the current Prospectus, relevant Key Investor Information Document (KIID) and Supplementary Information Document (SID) for the Fund. These can be obtained from Aberdeen Asset Fund Management Limited, Bow Bells House, 1 Bread Street, London EC4M 9HH.

Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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