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Bond master

Last month witnessed huge amounts of money being withdrawn from banks and building societies. Interest rates are so incredibly low that the average instant access account now pays 0.86 per cent. Building society savers are effectively being forced elsewhere in search of better returns.

I have even heard of people buying old shotguns as investments. The reason is simple – they can enjoy the asset and hope that its value will rise over the years. I expect esoteric investments like fine wine and classic cars to become more popular, too. These investments may have merit but, of course, a shotgun or bottle of vintage claret will not produce much income.

A somewhat more mainstream asset class that is seeing significant inflows is corporate bond funds. I have mentioned these before and although I am positive on the outlook for the sector, it is certainly not a one-way bet. While investment-grade corporate bonds yield between 5 and 7 per cent, they have fallen in price dramatically throughout this financial crisis because institutions have been selling them to raise capital. The result has been that yields have risen and current bond prices reflect a scenario worse than the Great Depression which, I believe, will probably not happen.

That some of these bonds will default is inevitable in the current climate but despite this, there is every chance that a well managed portfolio of bonds could give you a better return over the next two or three years than cash. Unlike cash on deposit, however, the value of your capital in a bond fund can fall. If you are not prepared to stomach fluctuations in capital or even losses, then you should not invest.

Standard Life Investments has considerable experience in the corporate bond area and it is interesting to note that it has just launched a new fund, the Standard Life strategic bond fund. It will be run by Andrew Sutherland who is head of credit at Standard Life Investments. I consider him and his team to be solid and they are experienced, too, which is just what you need in this sort of environment. Strategic bond funds can effectively go anywhere in the bond market in search of the best total returns yet, at least initially, Standard Life is keeping it fairly simple with a portfolio which will be invested 55 per cent in corporate bonds and 45 per cent in Government gilts.

From the gilt point of view, Sutherland is looking at gilts with a medium to long term until redemption where he can find the most attractive yields. Some other bond managers feel that gilts are overvalued at present and some have even spoken of a bubble. However, if yields to redemption are still over 3.5 per cent and interest rates are 0.5 per cent, I do not see much evidence of a bubble here yet. Indeed, I can see yields on gilts of 10 years or more going down to 2.5 per cent. Talk of a bubble in gilts is premature.

In terms of corporate bonds, the fund is likely to have 25 per cent in banks, including issuers such as BNP, Barclays and Deutsche Bank. This may be a controversial move, given the considerable pressure that the banking sector is under but the low prices of these bonds means there are potentially significant profits to be had if the banks pull through.

If the Government was to further nationalise banks and (like the US government did with Lehman Brothers) wipe out the bondholders, it could have some bad consequences. Hanging Lehman bondholders out to dry is widely considered to have been a huge error and has contributed to the current state of the bond market. In addition, how will any bank raise any money in future if bondholders do not have confidence that the bank will honour its commitments?

The big call for Mr Sutherland and other managers will be when to invest heavily in high-yield bonds. It feels too early at the moment but perhaps by the end of the year that part of the market will start looking more attractive. The beauty of a fund like Standard Life strategic bond is that you are leaving it to the fund manager to make these calls.

Mark Dampier is head of research at Hargreaves Lansdown

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Carry on cabby

Last week’s bank rate reduction and the onset of quantitative easing will increase conjecture as to when the mortgage industry will finally begin to see signs of recovery.

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