Whether using bond funds or investing directly, bond investing requires thinking about the outlook for interest rates, inflation expectation, credit spreads and currency direction (if applicable) and how those variables impact bond valuations.
In the words of Henry Cobbe at Elston Consulting: “It’s a number cruncher’s crunch-fest”.
He adds: “Our research process when discussing bond funds with [discretionary fund managers] or financial advisers is very much focused around where the bond part of their portfolio wants or needs to be positioned given the outlook for those key variables.”
Asset Allocator spoke with several DFMs to find out their investment approach regarding bonds.
When it comes to investing in bonds directly, Evangelos Assimakos, investment director at Rathbones Investment Management, says "apart from the obvious cost saving", it allows "one to have full control of the interest rate exposure of their client’s portfolio at any given time, to better align with their market views and expectations".
Tax advantages
Depending on the client mandate and individual bond selected there can also be tax advantages.
Assimakos adds: “Qualifying corporate bonds are exempt from capital gains tax.
“Lastly, but very importantly, a ‘bond ladder’ can easily be constructed through the use of direct corporate bonds; a client that has cash-flow needs over a series of months or years could have these matched with appropriate bonds, which mature at the time when the cash flow is required.”
At Rathbones, the decision-making process when using bonds starts with the top-down assessment of what part of the bond market the DFM wishes to gain exposure to.
It would then identify all bond funds that can potentially offer exposure to these desired areas, mindful of funds that may also expose it to areas it does not wish to be in.
Assimakos says: “Following on from that, the same rigorous approach we apply to all fund research would apply with bond funds. Thorough due diligence would include an extensive questionnaire answered by the fund management company. A series of meetings would be had to assess the fund manager’s investment philosophy and discipline, as well as their risk-management policy.
“Some bond funds we invest in offer a relatively narrow area of exposure – for example, emerging market debt – whereas others invest across all areas of the bond spectrum.
“Whether one is used or the other at a given time, will depend on whether we are comfortable with investing broadly through a fund, or [whether we] wish to increase exposure to a particular area of the bond market in a more focused manner.”
At Quilter Investors, the company selectively invests directly in Treasury bills and government bonds in its fund-of-fund portfolios, as well as using government bond funds.
Kristian Cassar, head of manager research at Quilter Investors, says: "Investing directly gives us more flexibility to pick the precise maturity of the bonds to which we want exposure. However, we would always access corporate bonds via a fund.
"The primary reason for this is diversification. Bond funds offer exposure to a large number of bonds across different issuers, sectors, regions and maturities. This helps reduce risk, particularly default risk. This is very relevant for riskier corporate bonds but is less relevant for government bonds."
“Another reason is the need to do in-depth credit research, which requires the support from a team of credit analysts who can conduct fundamental research as well evaluate covenants and bond documentation. A third reason is the active management of interest rate exposure."
At Charles Stanley, across its investment manager network and asset management business, both bond funds and direct bonds are used.
Oliver Faizallah, head of fixed income research at Charles Stanley, says the investment manager uses actively managed bond funds to capitalise on a manager’s skill on bottom-up credit selection or top-down macro view.
Faizallah says: “If we wanted a low-cost, broad exposure to a certain part of the bond universe, we could invest in a passive [exchange-traded fund]. If we wanted very specific exposure to a single holding then we would consider if a direct purchase were the best option.”
Meanwhile, at Downing, the investment manager’s bond portfolio only holds passive bond funds, which it says is the polar opposite to its equity portfolio.
Simon Evan-Cook, multi-asset fund of funds manager at Downing, says: “As we don’t hold corporate bonds, there’s no need to pay for active managers here, as we don’t believe they add value in single-issuer assets like gilts or US Treasuries.
“As such, we are looking for strong, reputable providers, good index replication and low charges. As a fund of funds, there are no tax advantages for us in holding gilts directly. So we prefer the extra diversification offered by collective vehicles such as funds or ETFs.”
When it comes to the pros and cons of using bond funds versus investing directly, Evan-Cook says for a UK resident direct client, the "obvious pro" for holding a gilt directly is that there is no capital gains tax payable.
He says: “There are no management charges either, which also helps. Against this, there’s the very slight risk that there’s a specific issue with the particular bond that you’re concentrated in, which might lead to unexpected losses.”
Advantages of actively managed funds
Charles Stanley’s Faizallah says actively managed funds, when chosen correctly, can give clients the exposure to very specialised teams who can use their knowledge in a particular part of the bond universe, to build a portfolio that could outperform the benchmark after fees over a long-term time horizon.
Chris Metcalfte, chief investment officer at Iboss, agreed that using bonds allowed him to outsource the technical work of buying bonds to specialists.
He said: "We would not consider directly buying bonds (or equities). For us to buy them directly would suggest we have an edge over the fixed income teams we use. Currently in the strategic bond space these are M&G, JPMorgan and L&G. With any due respect our me and our investment team, we do not feel we have such an edge."
This was a sentiment echoed by Alex Funk, who runs the portfolios at Schroder Investment Solutions.
He said: "Bond funds and ETFs are managed by professional fund managers, who have the expertise and resources to conduct in-depth analysis and risk management. This can be particularly beneficial in the bond market, where assessing credit risk and navigating changing interest rates can be complex. Specifically, when we start to consider more complex fixed income strategies which includes convertible bonds, AT1s and asset-backed securities."
Funk added that using bond funds can help spread risk over many different issuers and sectors, which is not as easily achieved when buying individual bonds.
Meanwhile in the UK there can be challenges with buying individual bonds on certain platforms, particularly in model portfolios. Bond funds meanwhile are widely available and can be traded on most platforms.
According to Peter Dalgliesh, chief investment officer at Parmenion, funds offer greater diversification of underlying bonds held, reducing risk around liquidity and idiosyncratic variability of yield and credit risk.
He adds: “This creates a more resilient and stable portfolio for investors and eases credit-specific risk that would otherwise arise in single credit investment. That reliability and dependability helps advisers with their financial planning, supporting the delivery of outcomes in line with expectations.
“There are tax advantages in investing directly in gilts, but given the primary purpose of bonds within a multi-asset portfolio is to generate an attractive income and ballast during times of market stress, that is likely to be of secondary importance for most fixed interest investors.”
Meanwhile, for Rathbones, the main advantage of using funds for one’s bond exposure is to spread the individual credit risk across a wider pool of issuers.
Assimakos says: “This advantage is most prominent when you wish to gain exposure to more niche markets, for example emerging market debt and high-yield bonds, where a large – in the case of EM debt, local – team of analysts is available to identify the best issuers and avoid the ones at greatest risk of default.”
