Are hedged global bond funds the same as strategic bond funds?

2unlimited91

Linton said:

The past 10 years have seen the largest capital growth in bonds ever.  Bonds were not intended to provide capital growth and this is making them less suitable for the purposes for which private investors need them. ie steady and consistent growth from reinvestment of interest uncorrelated with equity. To judge a bond fund on high capital growth is missing the point - if you want that go for equities.

Under current circumstances in particular I believe we need flexibility in our use of bonds.  Bond management is a mathematical exercise as unlike shares the costs,total returns and dates when those returns are received are fixed and known from the outset.  We as private investors would not normally have the knowledge or the tools to carry out the calculations.  So I am happy to leave the problem of bond selection to a manager.

How knowledgeable do we need to be, when 50% in a gilts tracker + 50% in a corporate bond tracker (or any other proportions you care to pick) would have beaten these strategic bond funds?

How knowledgeable can these fund managers be, when they can be so easily beaten?

I do take the point that returns from bonds may well be lower in the future. So perhaps include a percentage of cash in the mix (as well as gilts and corporate bonds). Perhaps the "strategic" funds' problem is that they, too, have been holding some cash (or short-term investment-grade bonds, which can be similar to cash) in anticipation of lower returns from bonds — but that they started doing it too soon (e.g. 10 years ago). Which once again makes me wonder: so how much (or little) do they know?

bowlhead99

2unlimited91 said:
How knowledgeable do we need to be, when 50% in a gilts tracker + 50% in a corporate bond tracker (or any other proportions you care to pick) would have beaten these strategic bond funds?

How knowledgeable can these fund managers be, when they can be so easily beaten?

I do take the point that returns from bonds may well be lower in the future. So perhaps include a percentage of cash in the mix (as well as gilts and corporate bonds). Perhaps the "strategic" funds' problem is that they, too, have been holding some cash (or short-term investment-grade bonds, which can be similar to cash) in anticipation of lower returns from bonds — but that they started doing it too soon (e.g. 10 years ago). Which once again makes me wonder: so how much (or little) do they know?

I can tell from the smileys that you're only being half serious, but the various different types of bonds that exist will have different risk/return characteristics at different parts of an economic cycle, and strategic bond funds use a variety of bond types and strategic or tactical allocations to take exposure to the credit markets from time to time, and will not simply hold 'a little bit of everything', because their investors want them to take a view on the best way to protect and/or grow capital and income where possible in accordance with a defined objective. 

It's certainly possible for an investor's personal strategy to be: "Oh, I'll just go half and half between these two bond types and use two tracker index funds to allocate to individual bonds within those types, based on the value of different issuer's bonds available in those markets, on the assumption that my needs are the exact same as the hypothetical average of all the retail and institutional investors on the planet who participate in those markets for whatever reason".

And then looking back at the chart, over this particular period: "Ah great, I 'won', without even needing to know what I was doing or what these bond types even mean. My retirement strategy will be fine for the long term then".

I don't believe that's the best way to approach investment in the credit markets:

- The overall market includes investment grade corporate, high yield corporate, government, emerging markets (both local currency and USD or GBP), index linked, long-dated, short-dated  etc etc, which different market participants will hold for different reasons within the many tens of trillions of dollars of credit opportunities. 

- Some individual investors may entrust all their investing to 'strategic bond funds' because they have no idea what allocation to use.

- Professional IFAs may allow some portion to float as 'strategic' while making deliberate allocations to other classes (e.g. high yield, gilts, IL/TIPs etc) based on the modelling they have done or the actuarial research they have bought in.

- Other investors sceptical that anyone really understands bonds or what sort of allocation between types of bonds makes sense, may just trust it all to a global bond index, where they buy a piece of all the bonds that happen to exist in investible free float simply because they exist (rather than because they are useful for a personal objective), and allocate the money in proportion of whatever value of different bond types happen to exist around the planet. Buying something "just because it's there" in that manner seems least likely to be suitable for ones personal objectives. 

Just as a quick cut-n-paste from some of what I said on aroominyork's previous thread where he was discussing benchmarking to a global bond index, in case some find it useful or relevant here. I know the thread is not about using a global bond index, but the comments are relevant to 'active vs index' for bonds in general.

The problem is that the global bond index is not telling you how the average investor such as yourself is allocating their fixed income investments. It is simply some aggregation of what a bunch of other individuals and entities with entirely different (and competing / contradictory) objectives have done.

So if insurance companies are holding x trillion of short dated investment grade corporate bonds, and US defined benefit pension funds are holding y trillion of US local government municipal bonds and z trillion of index linked treasuries, while hedge funds are holding b trillion of junk bonds, and sovereign wealth funds are holding c trillion of bank debt and retail investors are holding gilts in their ISAs and investment grade corporate bonds in their pensions etc etc... it is possible to index all that as some single measure of 'everything that exists, with some minimum liquidity criteria', but that is not what any of those other investors are actually holding for themselves, and it hardly seems relevant to what you, as an individual investor with particular objectives would want to achieve. 

The insurance companies with their specific and personal objectives don't want to hold 'everything that exists on the planet in the proportions that are available'. The banks and pension funds and sovereign wealth funds and high net worth family offices and active bond managers with their specific and personal objectives don't want to hold 'everything that exists on the planet in the proportions that are available'. They follow a plan for their own objectives. Vanguard are offering a global bond fund for the UK retail and institutional market and it only has five or six billion quid in it, while UK investors' holdings in the fixed income asset class would be measured in trillions. Because people invest in what they want, not what happens to exist.

So the idea that you should see how you are doing by arbitrarily comparing your bond mix to 'everything that exists as measured by the Bloomberg Barclays Global Aggregate Float Adjusted and Scaled Index in GBP', seems fundamentally flawed.

[The mix of what goes into a global bond index] is largely based on how many bonds, and of what type, corporates and governments have decided to issue. The sum total of what the governments and corporates have decided to offer, is not how you should decide what to hold. 

An analogy would be comparing your car to other road vehicles and wondering if you should perhaps add another three wheels because the average licensed road vehicle has more than the four you've got. But as you're not trying to transport an articulated lorryload of pallets or a busload of passengers, it doesn't matter what the average wheelcount or mpg measure of all vehicles happens to be. You decided to get a car, and within that, a particular class of car - whether you like the comfort, speed, practicality, economy, maintenance costs, towing capacity etc. To flip through the back pages of Car magazine and see what average price, number of doors, mpg, acceleration time is the 'weighted average', and play Top Trumps with your car against that theoretical car, is not something that needs to be done.

So, as comparing yourself to 'that theoretical car' is not something that needs to be done, as you probably don't want it; it is fine to pay for active management where someone who understands yield curves and economic and market conditions etc, helps to allocate your money among a range of options.

2unlimited91

bowlhead99 said:

I can tell from the smileys that you're only being half serious, but the various different types of bonds that exist will have different risk/return characteristics at different parts of an economic cycle, and strategic bond funds use a variety of bond types and strategic or tactical allocations to take exposure to the credit markets from time to time, and will not simply hold 'a little bit of everything', because their investors want them to take a view on the best way to protect and/or grow capital and income where possible in accordance with a defined objective. 

It's certainly possible for an investor's personal strategy to be: "Oh, I'll just go half and half between these two bond types and use two tracker index funds to allocate to individual bonds within those types, based on the value of different issuer's bonds available in those markets, on the assumption that my needs are the exact same as the hypothetical average of all the retail and institutional investors on the planet who participate in those markets for whatever reason".

And then looking back at the chart, over this particular period: "Ah great, I 'won', without even needing to know what I was doing or what these bond types even mean. My retirement strategy will be fine for the long term then".

I don't believe that's the best way to approach investment in the credit markets:

- The overall market includes investment grade corporate, high yield corporate, government, emerging markets (both local currency and USD or GBP), index linked, long-dated, short-dated  etc etc, which different market participants will hold for different reasons within the many tens of trillions of dollars of credit opportunities. 

- Some individual investors may entrust all their investing to 'strategic bond funds' because they have no idea what allocation to use.

- Professional IFAs may allow some portion to float as 'strategic' while making deliberate allocations to other classes (e.g. high yield, gilts, IL/TIPs etc) based on the modelling they have done or the actuarial research they have bought in.

- Other investors sceptical that anyone really understands bonds or what sort of allocation between types of bonds makes sense, may just trust it all to a global bond index, where they buy a piece of all the bonds that happen to exist in investible free float simply because they exist (rather than because they are useful for a personal objective), and allocate the money in proportion of whatever value of different bond types happen to exist around the planet. Buying something "just because it's there" in that manner seems least likely to be suitable for ones personal objectives. 

I'd agree that holding bonds that fit one's objectives is the key, rather than trusting a global index because it represents all the bonds out there. Typically, the objective is to have a more stable part of one's portfolio. As it happens, a global bond index seems to give you about 2/3 in government bonds, 1/3 corporate bonds, and excludes junk bonds. That sort of mixture will usually do a decent job of being relatively stable (when hedged to one's home currency, e.g. sterling). If the bonds out there were a different mix, that might not be the case.

Though I think it can work OK, I'm not so keen on the global bond index myself. I don't see much point in holding government bonds from other countries, when one is based in the UK. So I prefer to combine a gilts fund with a corporate bond fund. For the latter, that could be either sterling-only corporate bonds, or global corporate bonds hedged to sterling. As I said, holding some cash as an deliberate allocation is also valid.

What I'm sceptical about is paying a substantial fee for an active manager to

(a) pick the proportions of gilts, cash, and corporate bonds

(b) make tactical changes in the proportions

(c) make other "bets", e.g. not always hedging currency to sterling

(d) pick exactly which individual bonds to hold

This is not because I think I'm a genius, but because I think the ways an active manager is likely to add value here are limited. On points (b) and (c), I doubt they add value at all.

On (d), I can believe they might add value about which corporate bonds to hold, but it's extremely unlikely they can with gilts, which are basically all the same (unless you can predict how the yield curve will change, which is back to the things I doubt they can do at all). For cash, I can get higher rates myself than a fund manager could if I delegated holding my cash to them. If a fund manager effectively subtracts value when holding cash, adds zero value when selecting gilts, and might realistically add positive value when selecting corporate bonds, overall that is not great for added value.

On (a), I need proportions suitable for my portfolio. A professional manager would be probably better able to pick suitable proportions for me than I am able to, but then they haven't been given the task of selecting proportions for me, they're just running a fund with a certain remit. And it is not an exact science, anyway. So long as I can pick something broadly appropriate, that will do the job.

I suspect that where active bond managers are most likely to add value is in corporate bond funds, especially if their remit includes junk bonds. It might be worth paying active management fees there, if you want to push for more returns from some of your bonds. (Not the usual aim from holding bonds, but some may want this from part of their bonds.) I just don't see the point in also paying higher fees to hold gilts and cash.

aroominyork

2unlimited91, I’ve run your graph to ten years. I’ve left out Pimco since we know it underperformed Jupiter, and I’ve used IA for the corporate bond sector. Jupiter (brown) outperforms a 50/50 gilts (blue) / corporates (green) split, and it also gives you a smoother journey. However over the most recent five years Jupiter slightly underperformed the corporates while gilts, largely thanks to a recent spike, were a street ahead (similar to your earlier graph).

Re bowlhead’s comment that “Some individual investors may entrust all their investing to 'strategic bond funds' because they have no idea what allocation to use”. Well, that's me, though I’ve tried – and mostly failed – to make sense of fixed interest in multiple threads. I don’t think you are saying there is anything necessarily wrong with that approach?

I’m a little surprised by your comment “Other investors sceptical that anyone really understands bonds or what sort of allocation between types of bonds makes sense, may just trust it all to a global bond index, where they buy a piece of all the bonds that happen to exist in investible free float simply because they exist (rather than because they are useful for a personal objective), and allocate the money in proportion of whatever value of different bond types happen to exist around the planet. Buying something "just because it's there" in that manner seems least likely to be suitable for ones personal objectives.”  If you were to write the same about equities you would get a stream of passive vs. active backlash. Is fixed interest different from equities in buying an index?

I wrote the above before seeing your last post, 2unlimited91. On your last point about active management being worthwhile for junk bonds, I consider them pretty much a proxy for equities, albeit with slightly lower volatility. I think they make people feel good when they go up because “ooh, look how well mere bonds are doing” and then they have a habit of falling with a similar trajectory to equities.

Linton

aroominyork said:

2unlimited91, I’ve run your graph to ten years. I’ve left out Pimco since we know it underperformed Jupiter, and I’ve used IA for the corporate bond sector. Jupiter (brown) outperforms a 50/50 gilts (blue) / corporates (green) split, and it also gives you a smoother journey. However over the most recent five years Jupiter slightly underperformed the corporates while gilts, largely thanks to a recent spike, were a street ahead (similar to your earlier graph).

Re bowlhead’s comment that “Some individual investors may entrust all their investing to 'strategic bond funds' because they have no idea what allocation to use”. Well, that's me, though I’ve tried – and mostly failed – to make sense of fixed interest in multiple threads. I don’t think you are saying there is anything necessarily wrong with that approach?

I’m a little surprised by your comment “Other investors sceptical that anyone really understands bonds or what sort of allocation between types of bonds makes sense, may just trust it all to a global bond index, where they buy a piece of all the bonds that happen to exist in investible free float simply because they exist (rather than because they are useful for a personal objective), and allocate the money in proportion of whatever value of different bond types happen to exist around the planet. Buying something "just because it's there" in that manner seems least likely to be suitable for ones personal objectives.” 

If you were to write the same about equities you would get a stream of passive vs. active backlash. Is fixed interest different from equities in buying an index?

I wrote the above before seeing your last post, 2unlimited91. On your last point about active management being worthwhile for junk bonds, I consider them pretty much a proxy for equities, albeit with slightly lower volatility. I think they make people feel good when they go up because “ooh, look how well mere bonds are doing” and then they have a habit of falling with a similar trajectory to equities.

Bonds are very different to equities.  With equities you want a broad range because you have no idea which will do well and which wont. So you spread your risk.

When you buy a safe bond you know exactly what it is going to do for you.  It will pay a fixed amount in £ terms of interest until maturity at which point it will return the original £100 face value.  Nothing that happens in the meantime will change that.  So if you wanted a secure cash lump sum in say 5 years time you would buy bonds to a calculated bit less than that value now and with the known interest you would be certain of having your money in 5 years time.

So bonds are very like fixed rate interest accounts, 100% guaranteed for any amount of money by the government, with the advantage that you can sell them at any time, you dont have to wait until maturity.  If you were putting money into fixed rate savings accounts would you choose a random set of such accounts focussed on the most popular ones?

If things were just that simple life would be easy.  However you have the complication of market price for bonds prior to maturity, which can vary significantly.  But if it does all safe bonds would be affected equivalently - there wont be good and bad bonds.  

The second major complication is that bonds are not that easy to buy, you cannot buy them at par.  So most investors use bond funds which behave very differently to the underlying bonds.  The key difference is that there is no maturity date as most funds will hold bonds with a wide range of dates so you cannot focus your bond funds on a particular target. Thus, you lose the benefit of a known return.  This has the effect that the varying market price becomes more important than the interest, especially in current conditions where prices are at an all time high and cannot go significantly higher because would they incur significant negative interest - the purchase cost is higher than you would get from the future interest plus the £100 back at maturity. A rational long term bond investor would buy the bond when required and hold until maturity.

So for small private investors the whole area is rather messy. But one thing is clear to me - comparing safe bond funds in terms of total return is crazy, a bit like ranking goalkeepers by the number of goals they scored (in the oppponents net!).

2unlimited91

Linton said:

When you buy a safe bond you know exactly what it is going to do for you.  It will pay a fixed amount in £ terms of interest until maturity at which point it will return the original £100 face value.  Nothing that happens in the meantime will change that.  So if you wanted a secure cash lump sum in say 5 years time you would buy bonds to a calculated bit less than that value now and with the known interest you would be certain of having your money in 5 years time.

So bonds are very like fixed rate interest accounts, 100% guaranteed for any amount of money by the government, with the advantage that you can sell them at any time, you dont have to wait until maturity.  If you were putting money into fixed rate savings accounts would you choose a random set of such accounts focussed on the most popular ones?

If things were just that simple life would be easy.  However you have the complication of market price for bonds prior to maturity, which can vary significantly.  But if it does all safe bonds would be affected equivalently - there wont be good and bad bonds.  

The second major complication is that bonds are not that easy to buy, you cannot buy them at par.  So most investors use bond funds which behave very differently to the underlying bonds.  The key difference is that there is no maturity date as most funds will hold bonds with a wide range of dates so you cannot focus your bond funds on a particular target. Thus, you lose the benefit of a known return.  This has the effect that the varying market price becomes more important than the interest, especially in current conditions where prices are at an all time high and cannot go significantly higher because would they incur significant negative interest - the purchase cost is higher than you would get from the future interest plus the £100 back at maturity. A rational long term bond investor would buy the bond when required and hold until maturity.

So for small private investors the whole area is rather messy. But one thing is clear to me - comparing safe bond funds in terms of total return is crazy, a bit like ranking goalkeepers by the number of goals they scored (in the oppponents net!).

Comparing returns of safe bond funds can be relevant. The point is: why do some do better than others? The main answer is costs: lower management charges leave more return for the investor. As you yourself say above, the prices of all safe bonds tend to be affected by the same factors. This leaves active managers very little room to add value when selecting which safe bonds to hold. Hence the lowest cost funds, most of which are trackers, tend to do best in this area. That's the theoretical reason to favour trackers in this area. Comparing past performance just serves the purpose of checking whether these expectations are confirmed in practice.

(Junk bonds are in a different category. They are much more similar to equities, and so not very useful in providing a stable part of a portfolio, which is the usual aim when using bonds. Some investors will want to allocate something to junk bonds, anyway; others won't.)

Linton

2unlimited91 said:

Linton said:

When you buy a safe bond you know exactly what it is going to do for you.  It will pay a fixed amount in £ terms of interest until maturity at which point it will return the original £100 face value.  Nothing that happens in the meantime will change that.  So if you wanted a secure cash lump sum in say 5 years time you would buy bonds to a calculated bit less than that value now and with the known interest you would be certain of having your money in 5 years time.

So bonds are very like fixed rate interest accounts, 100% guaranteed for any amount of money by the government, with the advantage that you can sell them at any time, you dont have to wait until maturity.  If you were putting money into fixed rate savings accounts would you choose a random set of such accounts focussed on the most popular ones?

If things were just that simple life would be easy.  However you have the complication of market price for bonds prior to maturity, which can vary significantly.  But if it does all safe bonds would be affected equivalently - there wont be good and bad bonds.  

The second major complication is that bonds are not that easy to buy, you cannot buy them at par.  So most investors use bond funds which behave very differently to the underlying bonds.  The key difference is that there is no maturity date as most funds will hold bonds with a wide range of dates so you cannot focus your bond funds on a particular target. Thus, you lose the benefit of a known return.  This has the effect that the varying market price becomes more important than the interest, especially in current conditions where prices are at an all time high and cannot go significantly higher because would they incur significant negative interest - the purchase cost is higher than you would get from the future interest plus the £100 back at maturity. A rational long term bond investor would buy the bond when required and hold until maturity.

So for small private investors the whole area is rather messy. But one thing is clear to me - comparing safe bond funds in terms of total return is crazy, a bit like ranking goalkeepers by the number of goals they scored (in the oppponents net!).

Comparing returns of safe bond funds can be relevant. The point is: why do some do better than others? The main answer is costs: lower management charges leave more return for the investor. As you yourself say above, the prices of all safe bonds tend to be affected by the same factors. This leaves active managers very little room to add value when selecting which safe bonds to hold. Hence the lowest cost funds, most of which are trackers, tend to do best in this area. That's the theoretical reason to favour trackers in this area. Comparing past performance just serves the purpose of checking whether these expectations are confirmed in practice.

(Junk bonds are in a different category. They are much more similar to equities, and so not very useful in providing a stable part of a portfolio, which is the usual aim when using bonds. Some investors will want to allocate something to junk bonds, anyway; others won't.)

During the past 10 years with interest rates falling long dated bonds will have increased in price  much more than short dated ones, on the other hand they will be more volatile.  The time to maturity of the underlying bonds in a fund will have a far greater effect on published returns than charges.  If one can, it makes sense to align time to maturity with your timescales  for need of the cash or to achieve a desired strategy. If you cannot do that yourself you can pay someone else to.

What doesnt make sense is to base your time to maturity on whatever happens to be the largest issue around at the time.  It may be relevent that the main buyers of bonds (other than the BoE) are insurance and pension companies whose objectives are very different to those of a small investor.

But in any case high capital growth and volatility is the last thing you want with bonds particularly as that growth is somewhat illusory as the bond does not change and eventually returns to par.  

2unlimited91

Linton said:

During the past 10 years with interest rates falling long dated bonds will have increased in price  much more than short dated ones, on the other hand they will be more volatile.  The time to maturity of the underlying bonds in a fund will have a far greater effect on published returns than charges.  If one can, it makes sense to align time to maturity with your timescales  for need of the cash or to achieve a desired strategy. If you cannot do that yourself you can pay someone else to.

Agreed. So pick short-, medium- or long-term bonds, and gilts or corporate bonds, or some mixture of the above, and perhaps throw some cash in there too, to meet your needs. Or get an IFA to do that for you. (But you can't get a strategic bond fund manager to do it for you, because they don't provide you with a personalized portfolio-construction service.)

What doesnt make sense is to base your time to maturity on whatever happens to be the largest issue around at the time.  It may be relevent that the main buyers of bonds (other than the BoE) are insurance and pension companies whose objectives are very different to those of a small investor.

Fortunately, I wasn't suggesting doing that

I would suggest deciding what maturity of bonds suits you, and then looking for a cheap way of getting exposure to bonds of that maturity (because all high-quality bonds of similar maturity tend to behave similarly to one another, so cost is the next thing to consider after suitable maturity). A bond tracker fund of the simplest type (i.e. which buys all bonds of all available maturities) can be a good solution, if it coincidentally has a suitable maturity for you. An if it doesn't, there may be another bond tracker fund available, which explicitly only includes shorter- or longer-term bonds.

But in any case high capital growth and volatility is the last thing you want with bonds particularly as that growth is somewhat illusory as the bond does not change and eventually returns to par.  

That is often the case, given the usual role of bonds as a portfolio stabilizer. However, longer-term gilts (but not so much longer-term corporate bonds) may have a role in stabilizing a portfolio, despite their relatively high volatility in themselves, because they have some tendency to rise when equities are crashing.

aroominyork

Linton said:

But in any case high capital growth and volatility is the last thing you want with bonds particularly as that growth is somewhat illusory as the bond does not change and eventually returns to par.  

My guess is the vast majority of people buy bond funds rather than individual bonds and we do compare performance, taking into account IG/junks allocations and maturity. My question is: if you compare movements in a strategic bond fund's price to the fund's typical yield, what does the difference between the two tell? Is it any indication of how well the fund has performed?

2unlimited91 said:

Agreed. So pick short-, medium- or long-term bonds, and gilts or corporate bonds, or some mixture of the above, and perhaps throw some cash in there too, to meet your needs. Or get an IFA to do that for you. (But you can't get a strategic bond fund manager to do it for you, because they don't provide you with a personalized portfolio-construction service.)

Is your point that you know what price you are paying for the bond, you know what the coupon is, and you know when the bond will be redeemed... so, as long as the company survives (or your position is the queue of creditors survives), you know exactly what return the bond will earn you?

2unlimited91

aroominyork said:

2unlimited91 said:

Agreed. So pick short-, medium- or long-term bonds, and gilts or corporate bonds, or some mixture of the above, and perhaps throw some cash in there too, to meet your needs. Or get an IFA to do that for you. (But you can't get a strategic bond fund manager to do it for you, because they don't provide you with a personalized portfolio-construction service.)

Is your point that you know what price you are paying for the bond, you know what the coupon is, and you know when the bond will be redeemed... so, as long as the company survives (or your position is the queue of creditors survives), you know exactly what return the bond will earn you?

No, the point applies equally to buying individual bonds or bond funds with a tightly defined remit (i.e. trackers, or active funds where the mangers has limited discretion about what to buy).

The point is that, if you know the duration (e.g. an individual bond that matures in 5 years, or a bond fund with an average maturity of 5 years) and the credit quality (e.g. gilts or investment-grade corporates), then you know what you're getting.

And once you know that, minimizing costs should be the next consideration.

(There is a difference in how you manage your bond holdings with individual bonds or bond funds. E.g. you might look at it once a year. An individual 5-year bond will have become a 4-year bond after a year. A bond fund with an average duration of 5 years will typically still have a duration of 5 years (because it will have bought new, longer-term bonds to replace the shorter-term bonds that have been redeemed at maturity). In both cases, you could look at what you have once a year, and (if necessary) adjust it to meet your current needs, whether that is because your needs have changed or because the maturity of what you're holding has changed due to the passing of a year.)