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Engine room

Readers of my column will know how keen I have been on corporate bonds over the last year or more. I admit I was little bit too early with some of my recommendations, but the rally we have seen since March in corporate bonds should mean that most people are now in profit. The question I am constantly being asked at the moment is whether the rally is over or if corporate bonds is still a buy.

After a rally that has seen the corporate bond index move up by more than 23 per cent from its low point, it is easy to say that such performance will not be repeated during the next six months. Yet, while bonds were compelling value in the early part of the year, I still feel they look good value today.

The prices seemed to assume we were facing a second Great Depression but they have now risen to a point that suggests we are in for a more ordinary recession. I would not argue for taking profits, since you have to ask yourself where you will put the money. If you go back into cash then it will be more secure but returns after tax are no more than about 1.5 per cent if you are lucky.

Given that I believe interest rates will stay at these low levels for at least another year (and only move up very slowly), I think corporate bonds are still a reasonable buy that is worth the risk.

This week, I thought I would bring to your attention a fund that has had very little publicity – the Royal London sterling extra-yield bond. The reason I have chosen it is that, although the fund has been recovering, it has lagged behind many of its fellow high-yield, high-risk bond funds. I therefore believe it has a little bit further to go.

As one of my colleagues put it, a quarter of the portfolio is still not going up at all and some parts are actually still falling. The fund is effectively flying on three of its four engines but, even below full power, the fund it is currently performing well. If the other quarter gets going, the potential gain could still be significant.

Eric Holt, the fund’s manager, is one of the most dedicated investment professionals I have met. Like many bond managers, he made mistakes last year but the market changed so much and so quickly that it would have been impossible not to be wrong-footed on occasion.

There are two main areas of the portfolio where the recovery has been muted. One such area is the building society sector. Bank bonds have recovered significantly but bonds including those issued by Coventry, Kent Reliance, Newcastle and Nationwide building societies have suffered setbacks. In July alone, this hurt the fund for around 0.5 per cent of performance. The yield on each of these bonds is now between 15 and 20 per cent and Eric Holt believes they offer great value.

The other key area is structured corporate bonds. One example is Dragon Finance, the bonds of which are secured on a portfolio of Sainsbury’s supermarkets. The bonds remain unchanged at 50p despite the underlying security of Sainsbury’s, which seems highly unlikely to get into serious difficulties.

Mr Holt would like to add to his positions in some of these bonds since he believes they are fundamental undervaluations but none is being offered to him. That tells its own story, I think, as existing holders want to hang on to these bargain bonds.

The fund has a distribution yield of 10.53 per cent at present, which should scream loud and clear that this is a higher-risk bond fund. Yet I suspect we have well and truly passed the worst and patient investors could be rewarded. For the record, I continue to hold this fund and in fact added to my own investment in it last week after a meeting with Mr Holt. All eyes have been on the equity market but I think there is still a good risk/reward case for bonds.

Mark Dampier is head of research at Hargreaves Lansdown

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