David Stevenson: A bond that pursues novel strategies

Iget a stream of e-mails from readers and PR types imploring me to look at some new bond fund or other, which claims to be radically different from the rest. I have resisted these calls so far.

That’s not because I dislike bonds. Far from it – a diversified bond fund is worth its weight in gold. In fact, I’d much rather attempt diversification using a bond fund than trust in some shiny metal.

No, my reticence has been for two other reasons.

First, there is already a fine selection of bond funds out there that can satisfy any adventurous investor. Of the actively-managed funds, those run by M&G and GLG are pretty good and they don’t need a lot of augmenting, as bond markets are highly liquid and fairly efficient most of the time. There is also a big range of specialist corporate bond funds – which have seen some huge inflows in recent months.

Of the passive index trackers, iShares exchange traded funds (ETFs) let you track anything from sterling corporate bonds excluding bank bonds, through to global inflation- linked government bonds.

The only gap for me is bond funds that pursue novel strategies or clever ideas. iShares has a single emerging markets debt fund but it has rallied rapidly in recent months and is now unappealing.

Second, I can’t help but feel that nearly all bond funds are overpriced. That emerging markets ETF from iShares, for example, is currently yielding only 200-250 basis points more than the UK government All Stocks Gilt index fund. For me, that’s not adequate compensation for the extra risk. It’s a not dissimilar picture in many mainstream corporate bond unit trusts, where yields are only a few hundred basis points above gilts.

I have an old-fashioned idea about risky fixed-
income securities: I want an awful lot more yield for my extra risk – and 2 per cent isn’t enough!

My view is that bonds are at best fair value, and at worst overbought. So, until recently, I haven’t had any compelling reason to increase my bond holdings. But, in recent months, some interesting small bond funds have been opening up.

This month, a new offering from hedge fund Stratton Street Capital/EFG caught my attention. This “Wealthy Nations” Bond fund is trying to capitalise on a specific opportunity based on valuations: its selection criteria take in solely those bonds from countries where levels of indebtedness are low and yields relatively high.

It uses a scoring system to rank nations and various debt measurement overlays that produce a bias towards oil-rich states. Countries such as Qatar and the UAE are clearly not going to have problems paying down debt – their net foreign asset position is incredibly low.

Then the fund looks at specific opportunities. For example, everyone seems to be dumping Dubai paper but is this a good idea? Won’t Abu Dhabi step in and make sure that UAE debt is paid in full? Another example is Russia. Mention Russian top-tier debt and many would think you are crazy. But Russia actually has low levels of debt and the government has said it would back the debt of its largest part-state-owned companies. Stratton Street Capital reckons the yields on offer more than compensate for the extra risk.

Add it up and you find an emerging market debt fund that’s paying close to 8 per cent – at least 400 basis points above most UK gilts – all achieved with high credit quality.

Compare this fund with the iShares emerging markets debt ETF and you can see the logic. In the ETF, you’ll find Russian debt but also plenty of bonds from the riskier Turkey and Venezuela. Yet it is paying 200 basis points less in yield. Stratton Street Capital reckons this anomaly will be whittled away over the next months, and yields will move closer to 5 and 6 per cent – which implies a handy 20 to 25 per cent capital uplift on its fund.

adventurous@ft.com