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

aroominyork

Linton, you say credit rating is not relevant but surely a comparison of strategic bond funds must look at the quality of the holdings - though, as bowlhead says, you have to decide what type of fruit to compare your apples to. Perhaps the coupon (which you suggest) and the credit rating (which 2unlimited91 suggests) are approximate proxies for each other: the lower the credit rating, the higher the coupon? But when I am comparing funds rather than individual bonds, how do I assess the combined holdings' coupons -  by the fund's yield?

As a separate question, I understand (or I think I understand) that if a bond pays all the interest on maturity then the duration and maturity will be the same. If interest payments are made annually then duration will be less than maturity. For example, Jupiter Strategic Bond's average term to maturity is 10.14 years and its effective duration is 6.47 years. Those two numbers seem in balance for annual interest payments. But I cannot see the balance of Royal London Sterling Extra Yield Bond where the average duration is 4.8 years but the maturities are much longer: 35.9% in 0-5 years, 23.6% in 5-10 year, 6.3% in 10-15 years, 34.2% in 15+ years. Unless most of the last category (34.2% in 15+ years) are 16 years' maturity, the duration and maturity seem at odds with each other.

bowlhead99

You may find this Morningstar article useful on the difference between maturity and duration/ modified duration / effective duration. There are other ways of explaining it though of course, but Google might help you find one you like.

https://www.morningstar.co.uk/uk/news/69773/the-difference-between-maturity-and-duration.aspx

If a bond is paying out interest for lots of years into the future its relative attractiveness will be sensitive to market interest rate changes so a longer maturity would (all things being equal) point to higher duration

You might imagine that a higher yield bond will pay relatively more out before maturity date than a bond with a really low coupon, so as the timing of cash flows are on average much earlier than maturity, the 'effective duration' might be expected to be different.

Linton

aroominyork said:

Linton, you say credit rating is not relevant but surely a comparison of strategic bond funds must look at the quality of the holdings - though, as bowlhead says, you have to decide what type of fruit to compare your apples to. Perhaps the coupon (which you suggest) and the credit rating (which 2unlimited91 suggests) are approximate proxies for each other: the lower the credit rating, the higher the coupon? But when I am comparing funds rather than individual bonds, how do I assess the combined holdings' coupons -  by the fund's yield?

........

To tackle the problem rather more broadly.....
Bonds by their very nature are very simple (I am not talking about inflation-linked bonds which arent!).  You buy one because its duration, return and risk matches your objectives.  Unlike shares there is no great problem of which one to buy given the basic requirements.  You will get a high certainty of outcome assuming you dont go overboard on junk bonds, but you pay for that with lower returns than equity.

Sadly most bonds are not readily available to the small investor so we have to make do with bond funds.  Bond funds behave very differently to their underlying holdings as they hold what from an individual investor's point of view is a pretty random set of bonds, almost certainly not aligned to their objectives/timescales, and without the certainties provided by a fixed maturity date.   So they lose much of the benefit of individual bonds whilst retaining the disadvantage of relatively low returns.  However they are all we have.

How to decide which one to buy? The primary choice is the type ranging from pure gilts through to high yield/high risk corporate or EM givernment bond funds which is governed by your objectives. Which specific fund is pretty arbitrary. As I have said before total performance is not a good basis - it may just indicate a higher risk fund where the risk did not happen to materialise, and if you want return for risk you are better off with equity. In any case for a given remit the range of performances is much narrower than with equity funds. Coupon is only relevent to risk if the issue dates match, and generally the issue date is not immediately obvious.  For example there are very safe long term gilts around issued perhaps 15 years ago with a 4.5% coupon.  But of course their price is now very high and their yield to maturity low. Credit rating of the holdings is relevent but only in broad terms - it should match the remit. It does tell you what type of bonds the fund holds and in what proportions which in principle could be incompatible with its past performance.  But in general I would expect them to match.

Really the only thing you know about a strategic bond fund is its history, unless you have the knowledge and skills to determine and assess its strategy.  Using Trustnet Charting you can see how it behaved in a range of different market conditions.  Such funds have the freedom to invest in a wide range of funds at different times.  The only reason I am going for one, in a relatively small way, is that they have an objective that aligns with mine and access to the range of options necessary to achieve it.  Whether the investment will be successful I have no idea, but it does provide an addition to the Wealth Preservation ITs.

aroominyork

So there are two variables to consider when selecting a bond fund: credit quality and effective duration. And that is exactly what Morningstar shows on its nine-square grid on the Portfolio page for bond funds. I'll look at some specific funds to assess how reliable the grid seems, but in the meantime is there an up-to-date UK explanation rather than this one from the US website?

Just seen that hits a paywall so here is a cut and paste:

The horizontal axis focuses on interest-rate sensitivity as measured by the bond's portfolio effective duration.

Prior to October 2009, US taxable-bond funds with durations of 3.5 years or less were considered short-term (having limited sensitivity to interest rate change); more than 3.5 years but less than 6 years were considered intermediate term (having moderate sensitivity to interest rate change); and more than 6 years were considered longer term (having extensive sensitivity to interest rate change). In October 2009, Morningstar moved from the aforementioned static breakpoints to dynamic breakpoints.

On a monthly basis Morningstar calculates duration breakpoints based around the 3 year effective duration of the Morningstar Core Bond Index (MCBI).

Limited: To be placed in the limited section of the fixed income style box the fund's three year average effective duration needs to fall under 75% of the three year average effective duration of the MCBI (Morningstar Core Bond Index). For example, if the three year average of the MCBI = 5.935, limited funds would have a three year average effective duration < 4.45. These funds have limited sensitivity to interest rate change.

Moderate: To be placed in the moderate section of the fixed income style box the fund's three year average effective duration needs to fall between 75% and 125% of the three year average effective duration of the MCBI (Morningstar Core Bond Index). For example, if the three year average of the MCBI = 5.935, moderate funds would have a three year average effective duration >=4.45 and < 7.42. These funds have moderate sensitivity to interest rate change.

Extensive: To be placed in the extensive section of the fixed income style box the fund's three year average effective duration needs to fall above 125% of the three year average effective duration of the MCBI (Morningstar Core Bond Index). For example, if the three year average of the MCBI = 5.935, extensive funds would have a three year average effective duration >=7.42. These funds have extensive sensitivity to interest rate change.

By using the MCBI as the duration benchmark, Morningstar is letting the effective duration bands to fluctuate in lock-steps with the market which will minimize market-driven style box changes.

Municipal bond funds with duration of 4.5 years or less qualify as low; more than 4.5 years but less than 7 years, medium; and more than 7 years, high.

Non-US domiciled funds use static duration breakpoints. These thresholds are:

• Limited: <= 3.5 years
• Moderate: > 3.5 and <= 6 years
• Extensive: > 6 years

Vertical Axis: Credit Quality
Historically, Morningstar followed the industry practice of reporting the average credit rating of a bond portfolio by taking a weighted average of ratings based on data provided by the fund company. However, because the default rates increase at an increasing rate between grades (a mathematical property called convexity), this method systematically understated the average default rate of a bond portfolio. For example, for U.S. corporate bonds as of the date of this document, the spread in default rates between CCC and BBB rated bonds was over 21 times that of the default rate spread between BBB and AAA bonds. Yet, the conventional method assumes that these spreads are equal. To see the impact of this, consider a portfolio of 90% AAA bonds and 10% CCC bonds. According to the conventional method, the average credit rating of this portfolio is AA. However, the average default rate for this portfolio is that of BB bonds.

To correct this bias, Morningstar takes the convexity of default rate curves into account when calculating the average credit rating of a portfolio. The first step is to map the grades of a portfolio's constituents into relative default rates using a convex curve. Next, average the resulting default rates (rather than the grades) to come up with an average default rate for the portfolio. Finally, using the same convex curve Morningstar maps the resulting average default rate back into a grade. For example, a portfolio of 90% AAA bonds and 10% CCC bonds will have an average credit rating of BB under this new methodology.

Independent research confirms that the arithmetic average credit rating of a bond portfolio systematically understates the credit risk and that a more meaningful measure would be to average the default probabilities associated with each letter grade and then use the convex curve that relates the numerical representation of the letter grades to default probability to assign a letter or alphanumeric rating to the portfolio. This procedure is detailed in Appendix A.

Based on following breakpoints Morningstar maps the calculated average asset weighted letter credit rating (see Appendix A) for all portfolios on the vertical axis of the style box:

1. "Low" credit quality – where asset weighted average credit rating is less than "BBB-"
2. "Medium" credit quality – where asset weighted average credit rating is less than "AA-" but greater or equal to “BBB-”
3. "High" credit quality – where asset weighted average credit rating is "AA-" and higher

aroominyork

Linton said:

aroominyork said:

Linton, you say credit rating is not relevant but surely a comparison of strategic bond funds must look at the quality of the holdings - though, as bowlhead says, you have to decide what type of fruit to compare your apples to. Perhaps the coupon (which you suggest) and the credit rating (which 2unlimited91 suggests) are approximate proxies for each other: the lower the credit rating, the higher the coupon? But when I am comparing funds rather than individual bonds, how do I assess the combined holdings' coupons -  by the fund's yield?

........

To tackle the problem rather more broadly.....
Bonds by their very nature are very simple (I am not talking about inflation-linked bonds which arent!).  You buy one because its duration, return and risk matches your objectives.  Unlike shares there is no great problem of which one to buy given the basic requirements.  You will get a high certainty of outcome assuming you dont go overboard on junk bonds, but you pay for that with lower returns than equity.

Sadly most bonds are not readily available to the small investor so we have to make do with bond funds.  Bond funds behave very differently to their underlying holdings as they hold what from an individual investor's point of view is a pretty random set of bonds, almost certainly not aligned to their objectives/timescales, and without the certainties provided by a fixed maturity date.   So they lose much of the benefit of individual bonds whilst retaining the disadvantage of relatively low returns.  However they are all we have.

How to decide which one to buy? The primary choice is the type ranging from pure gilts through to high yield/high risk corporate or EM givernment bond funds which is governed by your objectives. Which specific fund is pretty arbitrary. As I have said before total performance is not a good basis - it may just indicate a higher risk fund where the risk did not happen to materialise, and if you want return for risk you are better off with equity. In any case for a given remit the range of performances is much narrower than with equity funds. Coupon is only relevent to risk if the issue dates match, and generally the issue date is not immediately obvious.  For example there are very safe long term gilts around issued perhaps 15 years ago with a 4.5% coupon.  But of course their price is now very high and their yield to maturity low. Credit rating of the holdings is relevent but only in broad terms - it should match the remit. It does tell you what type of bonds the fund holds and in what proportions which in principle could be incompatible with its past performance.  But in general I would expect them to match.

Really the only thing you know about a strategic bond fund is its history, unless you have the knowledge and skills to determine and assess its strategy.  Using Trustnet Charting you can see how it behaved in a range of different market conditions.  Such funds have the freedom to invest in a wide range of funds at different times.  The only reason I am going for one, in a relatively small way, is that they have an objective that aligns with mine and access to the range of options necessary to achieve it.  Whether the investment will be successful I have no idea, but it does provide an addition to the Wealth Preservation ITs.

So if you think a bond fund should be bought to provide reliable income and not growth (as unlimited also thinks), would your ideal fund have a performance chart where the price (not the total return) of the Income class would revert to the 0% line each time the fund went ex-dividend?

Linton

aroominyork said:

Linton said:

aroominyork said:

Linton, you say credit rating is not relevant but surely a comparison of strategic bond funds must look at the quality of the holdings - though, as bowlhead says, you have to decide what type of fruit to compare your apples to. Perhaps the coupon (which you suggest) and the credit rating (which 2unlimited91 suggests) are approximate proxies for each other: the lower the credit rating, the higher the coupon? But when I am comparing funds rather than individual bonds, how do I assess the combined holdings' coupons -  by the fund's yield?

........

To tackle the problem rather more broadly.....
Bonds by their very nature are very simple (I am not talking about inflation-linked bonds which arent!).  You buy one because its duration, return and risk matches your objectives.  Unlike shares there is no great problem of which one to buy given the basic requirements.  You will get a high certainty of outcome assuming you dont go overboard on junk bonds, but you pay for that with lower returns than equity.

Sadly most bonds are not readily available to the small investor so we have to make do with bond funds.  Bond funds behave very differently to their underlying holdings as they hold what from an individual investor's point of view is a pretty random set of bonds, almost certainly not aligned to their objectives/timescales, and without the certainties provided by a fixed maturity date.   So they lose much of the benefit of individual bonds whilst retaining the disadvantage of relatively low returns.  However they are all we have.

How to decide which one to buy? The primary choice is the type ranging from pure gilts through to high yield/high risk corporate or EM givernment bond funds which is governed by your objectives. Which specific fund is pretty arbitrary. As I have said before total performance is not a good basis - it may just indicate a higher risk fund where the risk did not happen to materialise, and if you want return for risk you are better off with equity. In any case for a given remit the range of performances is much narrower than with equity funds. Coupon is only relevent to risk if the issue dates match, and generally the issue date is not immediately obvious.  For example there are very safe long term gilts around issued perhaps 15 years ago with a 4.5% coupon.  But of course their price is now very high and their yield to maturity low. Credit rating of the holdings is relevent but only in broad terms - it should match the remit. It does tell you what type of bonds the fund holds and in what proportions which in principle could be incompatible with its past performance.  But in general I would expect them to match.

Really the only thing you know about a strategic bond fund is its history, unless you have the knowledge and skills to determine and assess its strategy.  Using Trustnet Charting you can see how it behaved in a range of different market conditions.  Such funds have the freedom to invest in a wide range of funds at different times.  The only reason I am going for one, in a relatively small way, is that they have an objective that aligns with mine and access to the range of options necessary to achieve it.  Whether the investment will be successful I have no idea, but it does provide an addition to the Wealth Preservation ITs.

So if you think a bond fund should be bought to provide reliable income and not growth (as unlimited also thinks), would your ideal fund have a performance chart where the price (not the total return) of the Income class would revert to the 0% line each time the fund went ex-dividend?

Looking at bond funds as part of a mixed equity/bond portfolio aimed at long term growth:

Yes, in the ideal world the price of a bond fund ignoring interest should remain pretty constant over the long term.  A bond fund should provide all the excitement of a fixed rate savings account. Though in practice it would vary a bit as market interest rates slowly wander, generally increasing slightly in value when equities fall and vice versa. This behaviour adds to the benefits of rebalancing.

The fact that bond funds have not behaved in this way since the great crash is not the fault of the funds, but rather a reflection of what has happened to the global bond market and interest rates.

aroominyork

Thanks, Linton. So can we apply that to a few examples and see what it tells us? The graph below shows the price of Income classes of a mix of bond funds from the cautious to the adventurous: Royal London Short Duration Credit (FE 17, 5 year total return 18.3%); Jupiter Strategic Bond (FE 29, 5 year total return 23.9%); Man GLG Strategic Bond (FE 37, 5 year total return 26.3%); Schroder High Yield Opportunities (FE 63; 5 year total return 22.1%).

Royal London has hugged the 0% line most closely, Man GLG and Schroder were similar (up until this Spring), and Jupiter outperformed. If I read your theory right Jupiter’s performance is based on growth rather than income and so it should be avoided. Man GLG produced a similar 5 year total return to Jupiter and, while it has a higher FE and had a rougher time this Spring, it hugs the 0% line better. 2unlimited91, who thinks fund managers add little value, might be especially wary of investing in Jupiter.

I realise I am not necessarily comparing like with like (as discussed by bowlhead) but I am focusing here on the income vs. growth discussion.

ColdIron

You should probably have used the Inc class rather than Acc for the Jupiter fund

aroominyork

Damn it - I thought I'd been so careful. So here it with Jupiter Income class which changes the story.

PS They are not total return, Linton - they are 'without income reinvested'. Total return 'with reinvestment' is below.

[Deleted User]

I have the Allianz Strategic Bond and it has behaved in the total opposite way of that chart (during the crisis). Be interesting to hear thoughts on it compared to others on the chart.