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Bonds have more funds

The torrid time for equities has by and large continued. The UK market has recovered from the losses of three weeks ago but we have seen some really vicious sector rotation, causing problems for equity managers.

However, one area that does seem to offer significant value unless we see banks going bust is corporate bonds. A precursor for a more permanent improvement in the equity market must be some rally in the credit markets. Strategic bond funds seem to offer a genuine investment opportunity.

This has been recognised by Jupiter which launched its strategic bond fund in June. The fund is managed by Ariel Bezalel who has over 10 years’ experience in fixed-interest markets. Mr Bezalel has a flexible mandate where he can invest in government, corporate and high-yield bonds. You might think these were all the same but they perform very differently in different economic cycles.

Government bonds perform well in a recession and falling inflation. These are the least risky as they are guaranteed by the Government. Investment- grade corporate bonds do well in an environment where there is some growth but where there is also low inflation and falling interest rates.

High-yield bonds need fairly buoyant economic conditions, rather like equities. The latter two are backed by companies but these are differentiated by their credit ratings.

These ratings basically indicate the potential risk of the company defaulting on its loan. The riskier the company, the higher the yield – in other words, investors are compensated with a higher yield for the extra risk they take with their capital.

The global credit crunch has caused a huge dislocation within the corporate bond market and opened up opportunities in areas such as the financials sector.

Clearly, this might sound bizarre as the banks are having a torrid time. In fact, the yields on the bonds issued by the banks have risen to such elevated levels that the current default rates are implying that one in five banks will actually default.

This is something that the majority of bond fund managers, including Jupiter, feel is unlikely.

The banks are trying to restore their balance sheets and focus on paying down debt, which is good news for their bonds.

The Jupiter strategic bond fund currently has a large exposure to the banks but its main focus is on the senior debt that has, to date, never defaulted.

We expect the problems in the banking industry to suffer more regulation, given their problems, and this will make them into boring businesses but this is exactly what bond managers like. They want reliable companies with robust business models with solid management and very predictable earnings.

Mr Bezalel’s investment process starts with an overview of the wider economy looking at where we are in the business cycle. This takes into account factors such as inflation and the interest rate outlook.

Once the prevailing environment is assessed, this allows the manager to focus on picking bonds with the best potential return based on their credit quality and yield against the economic backdrop.

The fund currently yields 7 per cent which, within an Isa or a Sipp, is effectively tax-free. It has grown to 70m in size, making it nimble. Fixed-interest markets are huge and liquidity can be a problem so a smaller fund should have a chance of outperforming.

Around half the fund is invested in the high-quality investment-grade corporate bonds. These are mainly in the financials sector where there are prospects for growth.

The other half is in high- yield bonds which are mainly in short-dated bonds that basically have a short life to maturity but these are in strong businesses. There is also good geographical diversification with exposure to the UK, US, Europe and other overseas markets.

As we are experiencing high inflation, it is hard to see interest rates fall but this is what I expect will happen at some point in the near future. This will be a good environment for many bonds. In fact, I believe that deflation is likely to be a problem in the next year simply because the paying back of debt is deflationary, not inflationary.

With the housing market also under severe pressure, this should lead to a fall in interest rates.

I believe bond yields are currently so attractive they will not be around for long and investors need to snap up opportunities through funds like this which is looking to take advantage of the high yields and deliver capital growth over the longer term.

Mark Dampier is head of research at Hargreaves Lansdown

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