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Capital idea

This Old Mutual global bond fund is putting capital preservation first

Facebook’s initial valuation seemed expensive to many investors. The $104bn the company was worth when it floated last month meant each of its 900 million active users was valued at nearly $120 of annual advertising revenue.

But this is nothing compared with the extent to which the sovereign bond markets of the UK, US, Germany and Japan are overvalued, according to Stewart Cowley, manager of the Old Mutual global strategic bond fund.

This fund is somewhat different to other bond funds. Mr Cowley manages it with capital preservation at the forefront of his mind. That is not to say he does not want to make money but there are times when capital preservation is important. The current economic environment is such a time. This does mean it is not a fund for investors seeking a high income. It currently yields about 1.5 per cent.

Mr Cowley sees sovereign bonds as absurdly overvalued but is loath to bet against them without a hedge in place as he believes the market is effectively rigged. Governments are buying their own bonds and panicked investors are fleeing the banking systems of Southern Mediterranean countries.

He holds US treasuries and UK gilts while simultaneously shorting German bunds. If German bunds underperform their UK and US equivalents, the trade will create a positive return for the fund. If they outperform, the return will be negative.

This in itself generates modest returns, yet if German bunds weaken significantly, perhaps as a result of quantitative easing or similar operations, the trade could be highly profitable, assuming UK and US bonds do not fall by the same degree.

A widespread sell-off of these sovereign bonds will occur eventually, according to Mr Cowley. Fear is driving the market but the rewards on offer are low relative to the risk being taken. He suggests it is akin to dodging motorway traffic to pick up pennies.

As for the European monetary union, Mr Cowley believes it is reaching the end-game, although there is no telling whether it could be days, weeks or months away. New rules on maximum deficits and the amount of debt countries can have as a percentage of GDP are being drawn up. Nations are losing their discretion to act and will have to comply or leave the union.

Many have asked why the euro has not fallen further in light of this. Central bank manipulation and even the Chinese buying euros to control the euro/dollar exchange rate are the culprit, he suggests.

At present, 85 per cent of the fund is exposed to sterling, though he regrets having not held more in dollars. The fund can invest up to 100 per cent in overseas currencies but while he believes sterling will have a crisis, he thinks this is a year or so away.

The outlook for corporate bonds is more positive. Mr Cowley is comfortable that companies have plenty of cash on their balance sheets while yields offer sufficient compensation for the risks.

He believes the Bank of England will conveniently continue to underestimate inflation so it does not have to raise interest rates. He points to urbanisation and increasing wealth in emerging nations as likely to have inflationary effects.

Many investors seem to be ignoring the potential for stubbornly high inflation but he has built protection into the portfolio via indexlinked gilts.

Given the portfolio’s current positioning, returns are likely to be muted in the short term. Some might argue you might as well hold cash. Ultimately, you are paying for Mr Cowley’s views and ability to time decisions correctly. His record suggests he gets it right far more than he gets it wrong.

In this environment you want a fund that does everything possible to protect capital while having the potential to capture the upside when the time is right. In my view, this fund looks like a good insurance policy.

Mark Dampier is head of research at Hargreaves Lansdown

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