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Bond bulls

The massive sweep of assets into corporate bonds this year has startled many but what has been even more surprising is the concentration of flows for two main providers – M&G and Invesco Perpetual.

That is not to say other groups have not also benefited from the drive towards corporate bonds but the assets these two groups have gathered outstrips by far the others combined.

The billions amassed by M&G and Invesco Perpetual have massively increased the size of their funds and begs the age-old question of whether or not the managers can keep pace with the inflows. But while this may be the typical concern in this scenario, perhaps the more relevant question to be asking in today’s investment climate is can managers contend with a reversal in flows?

Buying corporate issues may not be much of a problem, considering the record number of purchases so far this year, but whether managers can sell into a market that remains illiquid and dysfunctional, abandoned by the major buyers – hedge funds and investment banks – is another question. Only a few months ago, managers in this sector were stuck with funds they were unable to sell and had to mark down value, hitting performance and leading to further outflows. It was good, top-quality managers that got stuck in this loop.

The positive turn in sentiment towards corporate bonds has been a dramatic one. In February 2008, the Invesco Perpetual corporate bond fund was just over £2bn in size. At the end of April 2009 the fund, managed by Paul Causer and Paul Read, was touching on £4bn. It has almost doubled in the course of one year – a year in which the average sterling corporate bond offering fell in capital value by 8 per cent.

Three of M&G’s funds have also benefited from the trend. Its mainstream corporate bond fund had £1.1bn in assets in 2008 but jumped to £3.2bn by April 2009. M&G optimal income, managed by Richard Woolnough, went from less than £133m in assets at the end of February 2008, according to Morningstar statistics, to over £600m just over a year later. Meanwhile, M&G strategic bond, also managed by Woolnough, has risen from just £92m around the start of 2008 to end the year with £383.9m and in the opening months of 2009 the fund’s assets swelled to just under £1bn.

Woolnough does not see a problem with the influx of money into his funds. He says: “We are seeing around three new investment-grade bond issues in Europe each day. We are selective about what we buy, inflows allow us to take advantage of generously priced new issues as well as those being sold in the secondary market at bargain prices due to forced selling.”

Causer and Read also claim the increased size of their corporate bond fund has not posed a problem in its management and the two are holding just 2.8 per cent in cash despite such strong inflows.

But while these managers running such giant funds believe they can contend with significant outflows, can the same be said for all managers in this sector?

Mark Dampier, head of research at Hargreaves Lansdown, has some concerns about the inflows into bonds but not as to the ability of these managers to contend with such rapidly increasing sums. He points out that Neil Woodford’s performance was never hurt when his funds started taking in £1bn a year and more. His worry is more about whether they will be able to sell if there is a reversal in flows. “The danger with corporate bonds is if we see a kick-up at the long end of the gilt market (25-30 years plus) because of potential inflationary expectations. This could lead to a 20 per cent drop in long-duration corporate bonds.”

Noting that corporate bonds as an asset class have always caused him worry, Dampier is now nervous about what will happen if bonds fall off and funds start to experience outflows.

M&G and Invesco Perpetual say they are equipped to contend with sudden outflows. Read saw difficult liquidity conditions in the latter part of 2008 and notes that liquidity was managed by holding a combination of cash, gilts and paper with short terms to maturity. The Invesco corporate bond fund currently has a modified duration of five-and-a-half years. Woolnough is also holding what he considers to be quite liquid assets and believes he could handle a potential problem better than his peers should the situation reverse.

Overall, Read admits that while there are still liquidity issues in secondary corporate bond markets, it has improved since September. He does not expect liquidity to return to levels seen three to four years ago but he believes a consequence of changes is that the market will be priced better and as a result will be able to find its own liquidity. The availability of money and the large role played by non-bank financial groups has changed markedly, he notes, which should prevent a repeat of the illiquidity seen in the autumn months.

On the whole, corporate bonds have fared well of late, with the average fund up by 1.1 per cent over the six months to mid-May and featuring yields of around 5-9 per cent.

It would seem that investors’ money has been well placed in this sector but how long will this bull run last? If the money keeps flowing in that direction, can the industry keep up? More important, what will happen if the direction changes suddenly? The answer is unclear. Considering the situation last year was so unexpected, who can possibly say for certain that managers are fully prepared for such an eventuality?


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