Interest rates in most major Western economies are not going to rise any time soon. US Federal Reserve chairman Ben Bernanke has made it clear that interest rates will not move until 2013 at the earliest. Mervyn King and his colleagues at the Bank of England are likely to follow suit. In Europe, interest rates were, unbelievably, pushed up despite a huge debt crisis but they are going to fall again.
In this environment, one would have expected bonds to rise in value. The yields on German, US and UK government bonds have indeed fallen to historic lows as prices have risen and investors have sought a safe haven during the recent stockmarket volatility.
Yet this in itself is somewhat strange, given the level of debt these nations have. In contrast, the vast majority of other bonds have fallen in value. Corporate bonds, in particular, have had a difficult time, especially high-yield bonds, which tend to move more in tandem with equity markets. Similarly, anything with any financial involvement has fallen further as worries over the eurozone debt crisis continue.
Strategic bond funds, including the Artemis strategic bond fund, managed by James Foster, have also struggled. It could be argued that most have not been strategic enough. They have nearly all been bearish of government bonds in the UK. Some have even shorted the market, positioning themselves to benefit from falling prices when in fact they should have been long as gilt yields have continued to fall and prices rise.
Foster has about 6 per cent of his fund in gilts but still “hates them”. He believes the low yields say more about fear than anything else and while fear prevails, it seems possible for gilt yields to fall below 2 per cent. He prefers bank debt because it gives “more bang for your buck”.
So far, this has not proved correct but Foster believes there is still plenty of value in financial bonds. Banks have more capital now than they did two years ago, yet default rates for the financial sector are suggesting most banks will go bust.
We could see one or two failures but he believes we are at extreme levels of distress. Once panic subsides and confidence returns, he believes the fantastic yields on offer will fall, meaning prices will rise.
Elsewhere, Foster also sees plenty of value in corporate bonds gener-ally. Implied default rates on invest-ment-grade bonds have risen to 15 per cent over the next five years while the equivalent figure for high-yield bonds is around 45 per cent. This means the market believes 15 per cent of investment-grade issues and 45 per cent of high-yield issues will default. Defaults on this scale would be unprecedented and Foster believes these numbers are excessive.
Presently, around 45 per cent of the fund is invested in high-yield bonds, with just over 50 per cent in investment grade.
Foster suggests more quantitative easing will be announced across Europe, perhaps under a different guise, as Germans, for historical reasons, do not like the idea of money printing. We will probably see more QE in the US next year and last week the Bank of England announced a £75bn extension to its QE programme. Furthermore, Chancellor George Osborne announced credit easing – a new mechanism to stimulate bank lending whereby the Treasury, via the Bank of England, would buy billions of pounds worth of bonds, or debt, in businesses, with the aim of easing their cashflow and encouraging banks to lend more cheaply.
With a yield of around 5.6 per cent, the Artemis strategic bond fund, like many strategic bond funds, is offering an attractive level of income compared with cash deposit although, unlike cash deposit, the value of your capital will fluctuate. With no resolution to the eurozone crisis, we are trying to catch a falling knife and financial bonds will remain under pressure.
You have to wait for that ERM moment – when the outlook suddenly becomes clearer – ready to buy into funds such as Artemis strategic bond when the fog starts to lift.
Mark Dampier is head of research at Hargreaves Lansdown