Guiding investors through the global bond markets

Global fixed income markets stand in excess of £200tn (€235tn) and given their recent strong performance, many investors are paying much closer interest to them. Addressing their size and the diversity within them, it is crucial that investors understand how to analyse different sectors within the fixed income market, and how to assess a manager’s skill in being able to add value in their fund.

Government bonds are perhaps the best known and, currently, the least loved in the fixed income sector. We look for managers who have a proven macro-economic framework, which looks at changes in the growth and inflation outlook, and enables them to move their duration and curve positioning when they anticipate interest rates may change.

With the current low level of yields, we like managers that have the ability to invest in government guaranteed and quasi-government debt which offer a slightly higher yield pick up over government bonds. We also favour an ability to invest in UK inflation-linked bonds when, on a relative basis, they look more attractive than nominal government bonds.

In the corporate bond space, while top-down duration management is still important, we also look at a manager’s ability to perform bottom-up credit research on individual corporate issues. We value a strong team of credit analysts that can provide the manager with comprehensive coverage of the corporate bond market. Credit analysts are often appraised by their ability to avoid downgrades and defaults so we like managers with low levels of both across a credit cycle.

We also look at a fund’s risk profile as managers can reach for yield by purchasing lower quality bonds including sub-investment grade bonds, which can be more volatile. We utilise measures such as the information and sortino ratios, to understand their risk adjusted performance profile. We look to funds that rank highly on these measures over longer time periods, as this enables us to pick managers that have a proven ability to provide strong risk adjusted returns over a business cycle.

The strategic bond sector is among the hardest sectors to analyse as it has the most diverse range of funds. It includes funds that focus predominantly on corporate bonds with a small weighting to high yield bonds, funds that are predominantly high yield focused and it also includes some global multi-sector funds.

This means it is vital to understand what the fund objective is and what instruments and sectors they are able to invest. A fund that is reliant on a large weighting in high yield may not be the most appropriate for a cautious investor, while a manager with an insufficient range of sectors and instruments in which to invest may find his ability to add value restricted.

We seek managers who have demonstrated an ability to combine a top-down and bottom-up outlook and strategically shift between different sectors, when the macro environment is most favourable to them.

The emerging markets local currency sector is perhaps the most interesting as it has a wide range of countries with differing economic models and outlooks. The most important risk to appreciate is the local currency of the bonds in circulation. This can provide a source of strong returns, especially given that many developing countries have improving fundamentals relative to the developed world. However this currency exposure also exposes an investor to significantly more volatility, as currency movements can be sharp and sudden.

We search for managers that have an extensive team of economists and sovereign analysts who are able to cover disparate regions such as Latin America, emerging Asia and Eastern Europe. They must have a proven ability to predict when different central banks are likely to raise or cut interest rates and also understand the drivers of different currency markets.

Absolute return bond funds are one of the most recent asset classes in the sector. They claim to offer lower volatility than traditional bond funds but also significantly higher returns than cash.

You should aim for those managers with a sufficient range of instruments to enable them to generate positive returns in any market environment. A particularly enlightening metric is the correlation of a manager’s returns to different asset classes, as this can provide a good understanding of underlying betas in a fund.

Many funds claiming to be absolute return-orientated actually have high correlation to the credit, high yield and equity markets. These are the type of absolute return funds to avoid, as they merely add to existing exposures in these areas, albeit with less volatility.

We have a preference for funds that have a range of diversified strategies and that exhibit low correlation to broader risk markets, as it is these funds that are likely to provide positive performance when you are nursing losses in other parts of your portfolio.