Strategic bond funds: Flexibility, income & how to choose

Strategic bond funds can invest across the fixed income spectrum. This can include everything from traditional government and corporate bonds to riskier high yield names. This flexibility sees them regarded as one-stop shops for investors wanting broad exposure to the asset class – but how can you choose the best portfolio?

On this page, alongside our Elite Rated and Elite Radar strategic bond funds, we define strategic bonds, explore the various pros and cons to consider and explain how to find the best strategic bond funds.

• Strategic bond funds can invest across the entire fixed income spectrum
• They can differ in terms of duration, credit quality and geographic allocation
• Outcomes can vary depending on the manager’s skill and portfolio positioning

What are strategic bond funds?

Bonds are loans made by investors to governments or companies. The bond issuer (the ‘borrower’) pays fixed interest payments, called a coupon, and repays the capital on a future date. Most bond funds are restricted to a particular type of bond, such as investment grade corporate bonds or UK government bonds.

However, strategic bond funds aren’t restricted by such a remit. Their managers have the freedom to invest across the entire fixed income spectrum. This means their portfolios can contain a mix of government bonds, investment grade corporate bonds, high yield bonds, asset-backed securities and emerging market debt.

Key concepts every strategic bond investor should understand

Let’s take a look at each of the components that strategic bond fund managers need to consider when putting together their portfolios.

Duration and interest rate sensitivity

Duration measures how long, in years, it takes for a bond investor to be repaid through a bond’s cashflows, including both interest payments and the return of capital. In practice, duration is also used as a measure of how sensitive a bond’s price is to changes in interest rates.

Generally, the longer a bond’s duration, the more its price will fluctuate when interest rates move. For example, a fund with a 10-year duration will be riskier in a rising-rate environment than one with a shorter duration. One of the benefits of strategic bond funds is that their managers can adjust a fund’s duration in response to changes in their interest rate views.

Credit quality and the rating spectrum

Bond issuers are rated by credit agencies on the likelihood that they will meet their interest payments and repay investors’ capital. It helps investors gauge the level of risk taken.

Yield and income

The yield refers to the interest received from the bond. It is usually expressed annually as a percentage of the investment’s cost, current market value, or face value.

Why invest in strategic bond funds?

Flexibility is the key attraction of strategic bond funds. Diversification is another key benefit, as well as the income potential for the ability to invest in higher yield options.

Why ‘strategic bond’ doesn’t mean the same thing twice

No two strategic bond funds will be the same. The flexibility they enjoy means the skills of individual managers will be crucial. You’ll need to consider a fund’s objectives and investment process, as well as the performance track record of the manager at the helm.

The risks of strategic bond funds

Here are some of the main risks to consider with strategic bond funds.

Interest rate risk

Bond prices generally fall when interest rates rise, and the extent of that movement is closely linked to a fund’s duration. Duration measures how sensitive a bond or bond fund is to changes in interest rates. The longer the duration, the greater the potential price movement when rates change. For example, a strategic bond fund with a long duration is likely to experience larger losses in a rising-rate environment than a fund with a shorter duration. While strategic bond fund managers have the flexibility to adjust duration based on their market outlook, this does not eliminate interest rate risk altogether.

Credit risk

There is a greater risk of defaults from investing in lower-quality issuers offering higher yields. This is particularly the case should there be an economic downturn.

Flexibility risk — the ‘unconstrained’ problem

One of the key advantages of strategic bond funds is their flexibility. Managers can move between different areas of the bond market — including government bonds, investment grade, high-yield bonds and emerging market debt — depending on where they see the best opportunities or risks.

This flexibility can help managers respond to changing economic conditions, interest rate environments and market trends in ways that more traditional bond funds may not be able to. However, it also means investors are placing greater reliance on the manager’s decisions and asset allocation views. With more moving parts in the portfolio, performance can be less predictable and outcomes may vary significantly between funds and market cycles.

Currency risk

This depends on a portfolio’s positioning. Some strategic bond funds may invest globally without hedging currency risk. This can put returns at the mercy of currency movements.

How to choose a strategic bond fund

So, how can you choose the best strategic bond funds?

Understand what the fund is actually trying to do

The first question is: what is its objective? The fund’s fact sheet will state its aims. Is it capital growth, income, a combination of both? Is the manager aiming to preserve capital during volatile periods, or actively seeking higher returns through riskier parts of the bond market?

It’s also important to understand the fund’s investment flexibility and any constraints it operates under. The strategic bond sector is extremely broad and managers can have very different approaches. Some funds may be able to invest freely across the credit spectrum while others may have limits in place, such as a maximum allocation to high-yield bonds.

Because of this, strategic bond funds can be difficult to compare directly against one another. Two funds in the same sector may have very different risk profiles, duration exposure and income characteristics. Reading the fund’s literature carefully can help investors understand where the manager has freedom to act, where constraints exist and how the strategy is intended to perform across different market environments.

Check the current positioning

The latest fund factsheet will outline the portfolio’s positioning across key metrics, including duration, credit quality, and both issuer and geographic allocation. Pay attention to how the fund’s positioning has changed over time. The manager may give an overview of recent performance and how the fund has responded.

Assess performance consistency across market environments

The key determinant of success for a strategic bond fund is the skill of the manager at the helm. It will be their decisions that will largely dictate returns achieved. Therefore, it makes sense to know how they’ve performed in various market conditions. Do they boast a strong track record, or have they struggled in certain environments?

Seek independent research

It’s a very complicated area, so it makes sense to tap into independent research from expert investors. For example, FundCalibre’s Elite Rating provides investors with a detailed analysis of the most well-regarded funds in different sectors.

Where do strategic bond funds fit in a portfolio?

They can fulfil different roles, so it depends on the individual investor. For example, some may prefer to have them as a core fixed income holding due to their diversified nature. They can also play an important income role. Many strategic bond funds aim to deliver an attractive yield and, depending on the manager’s positioning, may offer higher income potential than more traditional government bond funds. Other investors may prefer to use strategic bond funds as a satellite holding to complement an existing bond allocation or an equity-focused portfolio.

Our process & how we select strategic bond funds

FundCalibre’s analysts subject strategic bond funds to close scrutiny and award the very best a prestigious Elite Rating. Those with future potential are classed as Elite Radar. The process starts with AlphaQuest, our proprietary quantitative screening tool that estimates the likelihood that a fund manager will deliver superior returns. Funds passing this test will be quizzed on their investment philosophy and approach to portfolio construction. This analysis will be subject to peer review before a decision is made.

FAQs about strategic bond funds