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Bond strategy

Contrary to expectations, gilt prices have gone through the roof this year and the yield on the 10-year gilt has fallen to a low of less than 2.9 per cent. The financial crisis has made people edgy and trades are being driven by fear rather than greed. According to James Foster, manager of the Artemis strategic bond fund, the gilt market is already discounting zero inflation and a double-dip recession. Bond yields have also been driven down by the prospect of more quantitative easing both in the US and the UK, so much so that if extensive QE is not announced when the US Federal Reserve meets on November 3, I would expect bond markets and indeed all asset classes to take a tumble.

James Foster expects interest rates to remain low, probably for six months. However, he does anticipate the attitude of central banks will change towards tightening, particularly in the UK where inflation is above target and he expects an interest rate rise around this time next year.

So unless we slip into a period of Japanese-style deflation, the background for government bonds over the next few years could become more challenging.

That is not to say opportunities in the fixed-interest markets do not exist. The Artemis strategic bond fund yields more than 5 per cent and there are opportunities in bonds that have yet to recover fully from their 2008 lows. This is most notable in financials, particularly bank bonds where requirements of the Basel III rules have driven a lot of activity. The legislation has meant financial institutions are more likely to repay their callable bonds in a shorter timeframe, meaning the repayment of capital at an earlier stage for holders. This has caused a strong rally in these stocks and has opened up opportunities to buy other types of bonds as banks refinance. The bottom line is that there are now abundant opportunities in high-yielding bank debt for fund managers to pick over.

It is an area in which Mr Foster has had a big part of the portfolio and although he has taken some profits, he still has around 40 per cent in financials. He believes he is being paid a considerable excess over government bonds for what is a much lower risk instrument than before.
Ironically, it is the traditionally lowrisk, lower-yielding bonds that look more risky, even though they are issued by strong companies. The attraction of high-yield bonds is they pay a higher income, which could help them provide a return in excess of inflation. In contrast, government and investment-grade corporate bonds have lower yields, which can mean they are more vulnerable to movements in inflation and interest rates and Mr Foster believes they look more fully valued.

For this reason, it makes sense for investors to turn their attention from investment-grade corporate bond funds to strategic bond funds or even high yield funds, depending on the desired level of risk. Strategic bond funds are more nimble and can use a larger range of the fixed-interest spectrum, so, in the event of a big sell-off in gilts, many strategic bond funds have powers to help protect capital. They can use derivatives to short bonds and take cash positions, although this can be at the expense of income.

Meanwhile, high-yield bonds are less affected by rising interest rates and instead more correlated with the economic cycle. Provided the economy stays on track, you have more protection in the form of a bigger yield. Although this area of the market is the most risky in terms of companies defaulting on their bonds, default rates have been falling sharply in the highyield market. Increased merger and acquisition activity has been good news too. Larger, leaner companies tend to take over smaller ones, which means bondholders in the takeover target suddenly find themselves with a less risky holding as it is backed by a stronger organisation.

If your clients are not already invested in strategic bonds, it could be time to start moving in this direction and this is a good fund to consider.

Mark Dampier is head of research at Hargreaves Lansdown

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