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Battle of the bonds

The credit crunch seems to have shot away the middle ground of investment. Few clients want plain vanilla funds, preferring either cash or emerging markets. Bonds have been distinctly out of favour, yet could be the best opportunity in 20 years, as one fund manager said to me.

One bond fund that is making full use of the range of Ucits III powers at its disposal is the M&G optimal income fund.

The fund is run by Richard Woolnough, who in my opinion is one of the top bond managers in the industry. He examines the current economic environment to help him make the best selection of bonds. This is important because different types of fixed interest will do better in certain economic environments. Government bonds tend to do well when inflation is low and the economic environment is relatively poor.

On the other hand, high-yield bonds thrive in a stable and growing economy. They have been hit hard in recent months as the economic outlook has become murkier but many managers, including Woolnough, believe they are now attractively priced compared with their risk.

Once asset allocation is decided, Woolnough can focus on sector and stock selection. He will take into account valuations, the covenants on the various bonds (the promises and restrictions on paying back money to bondholders) and liquidity (the ability to trade quickly, which outside government gilts can sometimes be difficult).

I think it is interesting to see Woolnough’s overview of the overall environment, particularly the housing market which will have a major impact on the economy and the fortunes of the influential finance sector. We are all aware now that the US housing market has been falling and in some areas, such as Miami, dips of almost 20 per cent have been seen. The housing problems have been caused by poor lending practices and a glut of housing, which are not the same problems we have in UK but Woolnough considers the UK housing market is likely to follow the US downward.

This is based on such indicators as mortgage approvals, which have fallen off substantially and are an advance warning for falling house prices. Woolnough believes that this year could see a fall of at least 5 per cent.

Perhaps you should remember that very few property commentators have been suggesting this. They prefer to use words such as flat. The trouble is that markets hardly ever go flat, they are either moving up or moving down. Given that the UK housing market has risen by around 200 per cent over the last decade, would it be surprising to see a move down? Surely, the answer is no.

The good news on bonds is that credit spreads (the difference in yield between government and corporate bonds) are now at their widest since 1983. Managers such as Woolnough consider them to represent excellent value at this level. An example is Kingfisher, which has a bond that pays 6 per cent more than gilts. Clearly, it is also more risky but Woolnough believes the extra yield is worth the risk.

A key area where he differs from other fund managers is in his small exposure to financials. As you might expect, bonds in financial companies have taken a tumble along with their share prices. Woolnough has cut exposure in this area and moved into higherquality bonds.

The fund has a yield of 5.56 per cent although this will vary over time. One major advantage to buying a bond fund is that if you hold it in an Isa or self-invested personal pension, the income is tax-free.

Brokers have been shunning bonds for the last couple of years, which is not surprising given their rather poor performance, but two years ago you were not being paid to take the risk. Now you are.

The credit crisis will not go on for ever (although it may feel like it) and this is the kind of fund that I believe will benefit over the coming years.

Mark Dampier is head of research at Hargreaves Lansdown

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