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Fund Focus: Global Bonds

Global bond has always been something of a catch-all sector, comprising various non-sterling specialist portfolios as well as funds seeking fixed-interest opportunities across the world.

Looking at performance over three years to the start of August, this diversity of mandate is clear to see, with a massive 125 per cent differential between the best and worst-performing vehicles (although UBS absolute return bond, with -34.8 per cent, is almost 30 per cent behind the next worst offering as it struggles to recover from a calamitous credit crunch).

Over a shorter 12-month timeframe, this spread of returns drops to a 27.7 per cent difference and all 57 funds in the peer group are in positive territory.

As might be expected in light of prevailing macroeconomic themes, emerging market debt vehicles are dominant over the past year, with Invesco’s offshore emerging markets bond fund top of the pile.

Manager Claudia Calich says the sector has fallen victim to rising risk aversion more recently, with the sell-off in May ending the streak of 14 consecutive months of positive returns for emerging market debt.

She says: “EM spreads widened in May and June due to credit concerns in European sovereigns and a flight to quality caused higher-quality credit to outperform lower quality.

“We remain overweight smaller countries, like Iraq, Pakistan, Sri Lanka, Tunisia and Dominican Republic, whose respective rates are attractive and tend to be less correlated to the broader market.”

Elsewhere, her fund has maintained a long held underweight in higher-rated credit, primarily China, as well as areas seen as expensive such as the Philippines, Turkey and Lebanon.

Calich says: “We believe the emerging market outlook remains positive and well supported by strong growth outlook, low financing needs, steady inflows and strong cashflows.”

With the three-year timeframe including the depths of the credit crunch, top-performing funds over this period have proved their mettle against the toughest of backgrounds.

Several are among the top overall funds in the three years since the credit crunch, benefiting largely from a period of equity-like returns in 2009.
Leading the pack with a return of 82 per cent is GLG global corporate bond, although current manager Galia Velimukhametova has only been at the helm since late last year, when GLG acquired Société Générale’s UK asset management business.

In October, the group repositioned the international bond fund to focus exclusively on corporate debt, renaming it global corporate bond, and Velimukhametova took on the mandate. On inheriting the portfolio, she highlighted ongoing value in credit coming into this year, although noted the imminent impact of reduced liquidity as central banks exit from quantitative easing strategies.

With that in mind, she reduced exposure to Europe early this year – although she remains positive on financials as fundamentals improve – and avoided much of the sovereign problems of recent months by avoiding peripheral markets.

She says: “As the world enters an age of austerity and with low inflation and low growth likely to stay, we believe credit looks an increasingly attractive asset class. However, there seems to be a growing disconnect between fundamentals and technicals that is causing bonds to underperform.

“At current spreads, credit markets are pricing in considerable uncertainty and rising default risk within the eurozone banking system. But we will look at buying financials again as the release of the banking stress tests should reassure market participants.”

In recent months, Velimukhametova has been rebalancing the portfolio towards the US while reducing Europe and is now underweight continental markets to reflect concerns over sovereign debt contagion.

Second in the peer group over three years is another broad fixed-interest mandate in the shape of Templeton global bond run by Michael Hasenstab.

He says recent years have presented significant stress tests for managers and the fund’s approach – seeking to profit from global trends and attractive valuations rather than momentum – has proved able to perform against very different market backgrounds.

He says: “We used the extreme market volatility during the financial crisis to build positions with strong fundamentals at distressed valuations. We added large exposures to currencies like the Korean won and Mexican peso, sovereign credits like Russia and Argentina, and duration exposure in countries including New Zealand and Indonesia at historically weak levels ahead of market inflection points. Consequently, we were well positioned to benefit from the past year’s normalisation of markets.”

Another top long-term performer is Old Mutual’s global strategic bond fund, run since last year by Stewart Cowley.

His major strategic call is being long Western bond markets to capture the yield decline and matching price appreciation.

According to the former Newton manager, the main strategic prize of this positioning is the convergence of Western and Japanese bond yields.

He says: “Inflation will fall away in the second half of this year and, either by market manipulation or natural forces, bond yields have got to come down.”

One of key long-term themes on the fund is what Cowley calls discriminating capital, which means avoiding investing in heavily indebted Western economies.

“We thought the problem would arise in the United States, leading to weakness in the US dollar and were surprised it showed up in Greece and led to weakness in the euro.”

He acknowledges contagion risk across Europe but Cowley also highlights the positive contagion effect of lower interest rates, which should allow bond yields to fall.

He says: “Declining bond yields are not a problem for bond managers because prices rise, so we are currently long duration. There are selected parts of the corporate bond markets – financials, ideas-based companies – that can do well in this situation.”

On the currency front, Cowley believes markets are presently rewarding countries that have embraced austerity, leading to a tough environment for the dollar as America continues spending.

“In Europe, we have embraced deficit reduction with the enthusiasm of a zealot while in the US there is much greater reluctance to balance the books. The US dollar holds a dominant position in the hearts and minds of investors but, over time, that credibility as the world’s reserve currency is being eroded.”

With such strong economic tailwinds, emerging market debt has seen an upsurge of interest in recent years and Investec is the best performer in this particular sub-sector over three years.

The group’s emerging markets debt fund, run by Peter Eerdmans, has just breached the £1bn level, generating performance by focusing on local currency bonds as opposed to dollar-denominated.

His team tends to be contrarian and early with its calls and typically has a value bias on the portfolio.

He says: “The current fiscal situation in most emerging countries is exceptionally strong, with debt to GDP ratios of around 40 per cent compared with 100 per cent in the West, meaning we can be confident on credit quality. Despite all this, emerging debt markets are still yet to fully price in this major fiscal strength.”

On the bond side, the team took profits on several of its long ideas earlier this year, recognising we are now at the back end of a strong run for emerging debt.

They moved long positions in countries including Turkey, Indonesia and Hungary to neutral in recent months, having benefited from a rally in markets running through last year.

After the strong run last year, Eerdmans sees 2010 as back to a relative value environment.

His fund is currently overweight Chilean local bonds versus underweights in Mexico, for example, and long in the Korean won and Philippine peso versus underweight in the Indonesia rupiah.

On the currency front, Eerdmans was largely neutral during the first half of last year but subsequently moved into areas sensitive to the region’s growth.

He says: “While the bond market looks set for a couponclipping year in 2010, currencies are benefiting from additional flows into emerging markets as developed issues continue.”

Rationale thinking

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Matthew Michael, product manager, Schroders emerging markets debt fund

Last year, we had an extraordinary amount of government intervention in financial markets and that has not been the case this year, so without the support that aided last year’s recovery, we remain quite cautious.

When we invest in emerging markets debt, we look to make a return of 10 per cent and not to lose debt, so we apply this to anything we buy within the bond universe. But in the absence of assets that will make 10 per cent, we stay on the sidelines. We simply say the world is not in the same policy environment as last year and valuations are very tight.

There are 52 countries in our universe and within that some are doing well and some have made policy errors. Tier-one countries are well managed with good growth dynamics, such as India, Chile and the Philippines. You can invest there, there are good dynamics but if volatility picks up you have to afford yourself the freedom to be defensively positioned and in those countries that means a local government bond with the currency hedged.

There are some more racy markets that we do like, countries with many opportunities such as Brazil and Turkey. In the past, the rewards to invest in these sorts of countries have been high but at the moment they are not sufficient and you should be cautious in the short term because we have to manage our risk.

People are seeking investments with a sound rationale behind them and that is why our fund works – they see emerging markets as a good place to invest but they want to take the best from it without taking on the volatility that you had to in the past. Also, it is good to have a vehicle that is not positioned near other assets they may have bought into such as equities and corporate bonds, offering something different.

We are working in a universe of around $8trn in issuance and within that is a lot of opportunity in as much as some bonds have a lot of liquidity. We have a big strategy with a big remit and we have a very robust portfolio.

The long good buys

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Kevin Adams, manager, Henderson overseas bond fund

Global government bonds are bifurcating between what is seen as safe havens – Germany, US and, paradoxically, Japan and the debt-ridden UK and then there are those developed nations that are perceived to be high risk – Greece, Spain, Ireland and Portugal.

So there is a lot of differentiation in the markets that would not have existed in the past and a few years ago most managers would have been ambivalent between buying Spanish or German debt, for example. As a result, you have to take a smart view now, which does give more risk but also more opportunity.

We like the long end of markets so we like long Europe and long US. We are heavy in long-dated bonds because we think the long-dated yield curves will flatten – it is basically about owning the core markets in this period of volatility.

We have sympathy with the bond bubble fears because the economic outlook is riskier than it was six months ago. We are in an environment where double dip and deflation chances are higher and, in that environment, Japan has told us that yields can be very low for a very long time.

That said, I do not think you can get a bubble as such in the bond market, you can take the view that essentially bonds are just money supply managers and budget deficits are never necessarily an impediment for lower bond yields.

’You have to take a smart view now, which does give more risk but also more opportunity. We like the long end of markets so we like long Europe and long US. We are heavy in longdated bonds because we think the long-dated yield curves will flatten – it is basically about owning the core markets in this period of volatility’

We do not hedge our currency, so when sterling is depreciating, our absolute returns are very strong, so the currency movement is a very material part of returns, so for investors it is very important to know the currency activity of the manager.

To know if we are heading for a double dip and deflation or not is the $64,000 question – we think we are seeing a pause in the recovery, which you would expect after a strong bounceback. But ultimately, things will reignite and will become self-sustaining and that obviously is not a good environment for bond funds. But the risk to that is that we end up with a Japan scenario and, with that in mind, there is a lot of safe-haven return that can be garnered from government bonds.

Earning Japanese

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Mike Riddell, manager, M&G international sovereign bond fund

The sector has not really sold anywhere near as much as I thought it would have done because its track record is phenomenal. It is an area that is looked at by the discretionary world more than by advisers, which is surprising because the performances of the fund have been so strong.

It sounds strange but if you are very worried about what is happening with regard to the sovereign debt crisis, buying into a government bond fund is a good idea. While investing in Greek bonds may end with huge losses, 10-year German bunds hit their lowest yields ever, down to 2.3 per cent, which, if bought a year ago would have given you very handsome profits.

The bond market is telling us that we are turning Japanese. A rough rule of thumb in the bond market is that the yield you have is equivalent to around the forecast growth rate plus the inflation rate – so if the bund yield is 2.3 per cent, then it is safe to say that the probable growth rate plus the inflation rate is reckoned to be around 2.3 per cent and that is incredibly low, like a Japanese environment. That is why people are buying into government bonds, people are worried and record inflows are going into fixed income.

So the fund is essentially positioned for the developed world to turn Japanese. The only European exposure is long-dated German bonds and we also have a long position in US bonds, since the US economy will be growing very slowly. I think emerging market currencies are a good place to be. I have exposure to the Malaysian ringgit, the Brazilian real and both the Mexican and Chilean peso. Europe is in trouble but Asia and Latin America are still healthy.

US economic data is woeful and that has begun to come over to the UK this month. The surprise has been that there has not been the wobbles in Europe but it will come – as the old adage says, if the US sneezes, the world catches a cold and with the downturn in the US hitting the UK now, it will spread.

Three D vision

Russell Silberstone, manager, Investec global bond fund

The big issues now for global bonds are the worries about the double dip and deflation. It has been remarkable how quickly the market has switched from the eurozone to growth outlook. But fears are understandable, most expectations have been disappointed by the recent data releases in Europe and the US. But we think central bankers, Ben Bernanke in particular, have learned their lessons and are doing all they can to avoid deflation.

Our fund has a reasonable position in high quality corporate debt because that is where we see value, you can see that in solid company results. We have exposure to emerging markets debt and we also have exposure to short-dated UK gilts because we think the yields are quite attractive, particularly where there is a bigger embedded inflation problem than the monetary policy committee cares to notice.

But it is hard to think there is fantastic values in bond markets at these levels, so we are modestly short. With US bonds as low as they are, it is hard to be bullish.

It is hard to be confident in our outlook, given all the uncertainties in global economies. We think the fund has the right asset mix but we would certainly think that if we did slip into a deflationary environment, bonds would perform well. We like emerging market bonds and we have some high quality investment-grade credit, so we are well structured for the next 12 months but I would be lying if I said we knew what the next 12 months held and I think policymakers would say the same thing.

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