What’s been driving returns in the IA’s Sterling Strategic Bond sector? Its portfolio managers have more flexibility than most to deal with the storms that have hit fixed income over the past couple of years.

We recently took a high-level view of the Sterling Strategic Bond sector, and have since received a sack full of requests* to delve deeper, in terms of how the sector has navigated credit quality and duration.

Average three-year returns for the sector (to end April 2024) were -2.64%, but vary considerably by quartile: from 7.42% to negative 13.62%.

Credit spectrum

Prior to the 2022 spike in inflation, yields were wafer thin, so managers were compelled to move down the credit spectrum to wring any income worth speaking of out of fixed income. Otherwise, you were just in a fix. It was an approach that worked, after a fashion, but coming out of COVID, with the fault lines in economies all too apparent, it was also one that by definition carried greater risk.

As things played out, this hasn’t been the risk to worry about—at least so far. While defaults are creeping up, they are still relatively low. As can be seen from charts 1-3, the Strat Bond funds that have performed best over three years have, in general, been biased to lower credit quality. The charts show two bars, the blue being investment grade; and black, BB to CCC credits (lower credit ratings have been removed for simplicity, as exposure is minimal).

Chart 1: Sterling Strategic Bond Credit Quality by Quartile (April 2024)

Chart 2: Sterling Strategic Bond Credit Quality by Quartile (April 2022)

Chart 3: Sterling Strategic Bond Credit Quality by Quartile (April 2020)

Source: LSEG Lipper

But first, some caveats. These averages are just that—even within quartiles, there is enormous variation. Strat bond managers have lots of levers to pull, and there’s more than just credit and duration effects through direct exposure to bonds at work. For instance, the worst performer over three years does have one of the largest IG exposures (as laid out in its mandate), but is also using derivatives such as swaps and futures to a far greater degree than its peers, and it’s not possible to see which is having the greatest performance impact at this level of analysis. On the other hand, the best-performing fund in the sector was running a cash position of 18.5% in April 2022, which can’t have hurt.

Such metrics are, however, useful for highlighting broad trends. Over the 12 months to April 2020, for example, fourth quartile funds (to April 2024) had the highest exposure to investment grade (73.95%) and first quartile the lowest (58.56%). In terms of exposure to BB, B, and CCC credit, first quartile funds had the highest exposure (35.83%) and fourth quartile the lowest (16.73%).

As inflation spiked (year to April 2022), IG exposure decreased across the second to fourth quartiles, although increasing by about 1.5 percentage points for the first. Meanwhile, there was more than a 13-percentage point difference in the exposure to BB, B, and CCC credit between fourth and first quartile.

Over the 12 months to April 2024, IG exposure has increased across all quartiles at the expense of high yield, although there’s still a bias away from IG in the first quartile relative to the third and fourth quartiles.

Maturity impacts

Why the bias to lower credit quality seems to have translated into better returns is likely because lower credit quality bonds tend to be shorter duration than investment grade: there simply aren’t that many 10 year-plus CCCs out there. And duration has been the real killer in this market, which is why bond funds with short-duration mandates have tended to rise to the top of sector performance tables over the past couple of years.

The average sector modified duration for the past 12 months is: fourth quartile, 8.17; third, 5.12; second, 6.38; and first, 3.34—so fourth quartile funds are running about 2.5-times the duration of their first quartile peers. And we can see this played out in the maturity profile of bonds held by quartile.Chart 4 takes the year to April 2022, but we see a similar pattern two years prior to this.

Chart 4: Sterling Strategic Bond Maturity Profile by Quartile, April 2022 (%)

(Click on image to enlarge)

Source: LSEG Lipper

Exposure to bonds of 10-20 years for fourth quartile funds is more than double that of for the first quartile (16.08% versus 7.41%), while the situation is reversed for maturities of one to three years (7.46% versus 17.22%). It’s a similar situation to April 2020; also similar for maturities of 10-20 years in 2024, although maturities of one-to-three years have increased in the fourth quartile and decreased in the first.

What will be interesting to see is, if and when rates decrease, how this impacts the sector: will the last be first when duration becomes your friend, or will—at least some—leading managers be nimble enough to position their funds to ride the wave back?

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