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Bouncing bonds

Continued turbulence in bond markets has sent Pru rushing for shelter while investors appear to be abandoning the sector as better opportunities become available in cash. Yet Chris Salih says not all fund managers are so bearish and some are beginning to see reasonable value in the asset class

Prudential has taken a defensive stance across the corporate bond holdings in its £73bn with-profits fund, hedging much of its exposure due to concerns about the impact of private equity on the market.

It has tapped into the credit default swaps market to hedge all its high-yield debt exposure and 25 per cent of its investment-grade exposure.

Investment director Martin Brookes says he wants to de-risk the portfolio in light of concerns about private equity and the amount of cov-lite and leveraged loans being used. The weakness in the US sub-prime mortgage market is another concern.

Brookes says: “A lot of excesses have been seen in private equity and we need to unwind that. Over time it is inevitable that the pace of the private equity market will slow.”

Not all fund managers are so bearish on the asset class and Aegon Asset Management investment manager, UK retail, Euan McNeil believes the threat of highly leveraged private equity deals is waning.

He says: “Until a couple of months ago, there was little restriction on what private equity could do as we were still keen to lend them money. That has changed as lenders now want more covenants and are more risk-averse, which is healthy for the credit cycle.

“Gone are the days when a £1.4bn deal could be refinanced with a firm borrowing £1.3bn and a private equity firm shelling out just £100m up-front.”

M&G bond manager Richard Woolnough says banks may be becoming more cautious on their lending but there are still sufficient leveraged buyouts taking place to temper his growing optimism on corporate bonds. He says: “Private equity is still there as is indicated by the number of leveraged buyouts taking place in the market and the amount of capital being raised. For that reason alone, it is best to stay conservative to ensure higher control.”

However, Woolnough believes duration risk is reducing following a difficult period for the market, characterised by a series of interest rate rises, a couple of which caught markets out.

He says: “Global interest rates appear to be normalising. It is inconceivable that the US Federal Reserve will raise interest rates any further and there is a good chance that rates will start falling towards the end of the year.”

He expects UK interest rates to reach 6 per cent and says the market is already pricing this in. Greater certainty about rates has enabled him to move to a durationneutral position, moving from two-and-a-half years to around five years.

He says: “Bonds now look reasonable value. Including the small allocation to equities, the entire fund’s duration is now around five years which represents a fairly neutral-duration position, reflecting my more positive view on bonds.”

This renewed optimism in some quarters has not been reflected in investor sentiment. Corporate bond funds were the darling of investors during the latter half of the equity bear market but recent performance has taken its toll on sales.

The Investment Management Association’s corporate bond sector was the poorest performer in the first two quarters of 2007 and the sector has delivered average returns of -1.1 per cent over the past 12 months.

This is reflected by the fact that all six bond sectors comprised only 18.1 per cent of gross retail and institutional sales for June 2007 compared with 20.6 per cent in June 2006 and 24.6 per cent in June 2005, showing the gradual move away from the asset class.

Hargreaves Lansdown senior adviser Ben Yearsley says the impact of continual interest rate rises over the past 12 months has made cash a more attractive option for investors than bonds.

He says: “If cash funds are offering 6 per cent without any risk, why would an investor bother to get involved in a bond fund that cannot compete with that figure and has potential risk?

“The problem is that a number of bond funds do not look that exciting at the moment. The best options for investors is to go into emerging market bonds that offer 9 to 10 per cent or go into funds that can go anywhere in the market like Artemis strategic bond fund.”

Bestinvest head of communications Justin Modray says all types of bond fund face major issues, meaning no market segment is looking attractive right now.

He says: “Investment-grade returns have been zero for the past year, reflecting the impact of inflation, and with interest rate rises still a possibility it is hard to see those threats going away in the short term. Then you have the credit crunch at the other end of the market that has seen the stockmarket struggle and subsequently high-yield bonds falter.”

The concern over bonds has been reflected across a number of multi-manager active, balanced and cautious portfolios, where many managers are preferring to have as big a cash allocation as fixed interest.

Modray says: “You can understand their views as multi-managers because they are designed to be safer performing investments and at the moment hiding the cash under the mattress seems safer than putting money into a bond fund of any shape or form.”


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