Switching between high yield and lower risk investment grade debt will enable bond investors to make competitive capital gains in the coming years, according to Artemis’ James Foster.
Foster, who heads up the £595m Artemis Strategic Bond fund, accepts that a rising interest rate environment will make it difficult for fixed interest managers to repeat the stellar returns they have experienced in the last 30 years or so.
However, he believes that being nimble and flexible will enable bond funds to generate decent capital returns, as well as a solid and predictable coupon.
At the moment the manager is overweight high yield debt and short-dated bonds, although he is ready to change his focus once valuations rebalance.
“Generating capital gains in a rising interest rate environment for bond funds is much more difficult,” he said.
“As the economy normalises and growth resumes, then it is inevitable that interest rates will have to rise. The question is not if this happens, but when.”
“We are able to protect on the downside by using interest rate futures and there are always some positives in some bond asset classes. For instance, whilst government bond yields may be rising, high yield bond yields may be falling, because the economy will be improving.”
“Further, shorter dated bonds and floating rate bonds both offer protection.”
“So, whilst capital gains are more difficult to achieve, they are possible with a nimble and proactive strategy.”
Foster proved last year that it is possible for investors to make good money in bonds even as yields rise.
His fund sits in the IMA Sterling Strategic Bond sector, which allows managers to have unlimited exposure to investment grade, high yield, sovereign and corporate debt – as long as 80 per cent of the portfolio is sterling denominated or sterling hedged.
FE data shows that his four crown-rated Artemis Strategic Bond fund returned 7.29 per cent over the 12-month period, compared with 2.27 per cent from the IMA Sterling Strategic Bond sector average and just 0.87 per cent from the iBoxx Sterling Non Gilts All Maturities index.
Performance of fund, sector and index in 2013
Source: FE Analytics
Some areas of the US long-dated market fell by up to 20 per cent in the early summer of last year, but as Foster mentioned earlier, his aversion to this area of the market enabled him to dodge this bullet.
As well as performing strongly from a total return point of view last year, Artemis Strategic Bond was also less volatile, and lost less during the down months of May and June – even though it is overweight riskier areas of the market.
Commenting on the strong performance, Foster said: “Our proactive strategy of shifting between the different asset classes of government, investment grade bonds and high yield bonds has been broadly correct.”
“Furthermore, a strategy of overlaying using futures has contributed to performance. Meanwhile, within the high yield universe we have been very selective and avoided most of the pitfalls which can occur if proper credit analysis isn’t undertaken.”
High yield and BBB-rated debt – defined by Foster as “lower quality investment grade debt” – currently has an 80 per cent weighting in the fund. The manager says he is ready to shift to higher quality areas, which have become more attractive in recent months.
“If the economy shows sign of weakening again, then we would quickly look to reduce this and our percentage in government bonds would increase,” Foster said.
“A year ago when US Treasuries were yielding 1.5 per cent, they represented no value whatsoever. Now they have doubled. To still argue that they are as overvalued would seem wrong. We suspect they are now more fair value, given that interest rates are likely to stay low for a while yet.”
Foster remains wary of emerging market bonds, which he thinks deserved their vicious sell-off last year.
“Emerging market bonds have had a wretched time and rightly so,” he said. “There is a reason that these countries have low debt-to-GDP ratios – they often default, either through high inflation or non-payment of coupon.”
“Admittedly there are exceptions to every rule, but I feel the current yields do not compensate for the risks of these factors and yields should go higher.”
He is more optimistic on financials however, and thinks the strong performance in this sector will continue.
“Financials do have further to run as they still yield more than the average corporate bond. They do have their risks, though,” he explained.
“New ones, in particular, have far more provisions for impairment should the bank come into trouble and arguably they are junior to equity. Predominantly we have focused on the older bond issues from banks, which should continue to perform well as banks rehabilitate themselves.”
Financials – including banks – currently have a 25.2 per cent weighting in Artemis Strategic Bond, making it Foster’s biggest sector position overall. Top-10 positions include a 1.7 per cent stake in the debt of RSA, as well as a 1.4 per cent position in Investec Bank.
Telecom, Media & Technology is Foster’s second biggest sector weighting, at 12.3 per cent.
Foster has run the fund with co-manager Alex Ralph since its launch in June 2005. Our data shows that the fund is a top-quartile performer in its sector over the period, with returns of 65.44 per cent. It is also ahead of its peer group over one, three and five years, as well as its benchmark.
Performance of fund vs sector and index since launch
Source: FE Analytics
It is currently yielding 4.2 per cent, which is a little above average for a Sterling Strategic Bond fund. While many investors assume it is no longer possible to get a decent yield from bonds, Foster says there are still areas that have inflation-busting yields – even those of relative high quality.
“The fact that the yield is a little higher than the competition is due to our asset allocation. We are specifically targeting high yield and financial bonds as the best returning asset classes in a rising interest rate environment,” he explained.
“In the future, the yield may well fall again when we shift into government bonds or high quality bonds. Our exposure to the highest risk CCC rated bonds is only 2.4 per cent – as ever, we remain focused on credit quality.”
One issue Foster is very wary of at the moment is inflation – a common enemy to bonds – which he thinks could rear its ugly head if quantitative easing (QE) continues.
He explained: “The point of QE was to replace bank capital being destroyed as banks rebuilt their balance sheets and reduced their lending.”
“Without QE, then the money supply would have contracted sharply and we may have seen a period of deflation. So QE has not been inflationary so far – it just prevented a period of deflation, which would have ensued without it.”
“The issue becomes if they leave QE for too long, then it will inevitably lead to higher inflation. The danger is that politicians and policymakers view QE as an easy fix and therefore continue the policy, risking much higher inflation. The appointment of Janet Yellen as Fed chairwoman, renowned for being more dovish, suggests this is a very real risk.”
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
This article was written in collaboration with and is sponsored by Artemis Fund Managers.
