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Make the grade

A couple of weeks ago,multi-managers were talking of seeing value ininvestment-grade fundsagain after a tough time forcorporate bonds – with theaverage corporate bond funddown 3.8 per cent over the 12 months to March 3.

For example, at a conferenceoutlining their take on thecurrent market environmentearlier this month, New Starfund of funds manager Mark
Harris said: “If you think all thebad news has been priced intocorporate bonds, then youshould be buying them – theyare pricing in a pretty grimoutlook.” But then thingspotentially have got grimmerin just those few weeks.
Corporate bonds, and thefunds that invest in them,have not been too popularsince the credit crunch andthe problems from the USsub-prime crisis. The ensuingflight to quality has seenspreads widen out so substantiallythat many managershave been eyeing the opportunitiesthat have beenemerging – particularly at the
investment-grade end ofthe market.
However, this past weekproved the bad news for thecredit sector may not yet beover and corporate bondsmay continue to struggle forsome time yet, despite thefact that spreads, at theirwidest in years, areenhancing the appeal ofthese investments.
Last week, talk of thepotential collapse ofGuernsey-based investmentfund Carlyle Capital madesome managers cautiousagain, despite these attractivespreads. Succumbing to thecredit crisis, Carlyle Capitalreported that it expected itslenders to take over all itsassets after talks with banksto refinance its $16.6bn debtfailed. Apparently, hopesthat its parent, Carlyle Group,would step in are consideredunrealistic, the press hasreported, noting the fund hasreceived margin callstotalling some $400m on itsportfolio of US governmentagency residential mortgagebackedbonds, likely spurredby continued worries aboutsub-prime assets.
According to Threadneedle,credit markets remain underpressure and spreads for bothinvestment grade and highyield continue to widen.“We prefer the prospects forthe former and believe thatthe default rates implied bycurrent spreads are unlikely tobe realised. The fundamentalsfor emerging market bondsremain supportive, notablythe continuing strength ofcommodity prices,” notesSarah Arkle, chief investmentofficer with Threadneedle.
The firm is currently overweightemerging marketbonds, underweight governmentand corporate debtwhile neutral on high yield.
Arkle adds: “High-yieldindices are pricing in defaultrates double the level of thepeak annualised rate of 10-12per cent seen in the recessionsof 1990 and 2003. Creditappears to be reflecting boththe perceived risk of defaultbut also the high levels ofleverage which were createdthrough structured instrumentsand are now in theprocess of being unwound.”
Jeff Keen, manager of theTriAlpha International Bondfund, says he is not hugelyoptimistic from a yieldperspective on the marketand is making plays oncurrency within the fund toaid returns. The TriAlphafund is an investment gradelong-only portfolio and atthe moment is structured asa Jersey unit trust. However,the firm is in the process ofseeking approval to set it upas a Luxemburg Ucits III fund,which would enable it tocontinue with its absolutereturn mandate.Keen says that while he seesvalue in corporate credit atthe moment, he remainscautious on being too earlyin. With such economic
events as the market isseeing, there is always a leadand a lag – time when youhave to let the bad news hitthe markets, he notes.
“Now is the time to startthinking about investing andin the next six months youwill probably see a quitedramatic shift,” he says.
The fund has been runningsince 2003 and from 2006 theportfolio has featured astrong AAA bias and has onlyslightly relaxed to consist ofAA+ today, but Keen says insix months time that averagecould go down to single A ashe looks to capitalise onsome of the value being seenin corporate credit today.
Richard Woolnough,manager of M&G’s corporatebond fund, like othermanagers in his space, hastaken advantage of widerspreads to add a smallamount of credit risk to hisfund but he is avoiding highyield bonds because spreadsare still not pricing in therisk of recession.
“Over the remainder of2008, central banks aroundthe world will be cuttinginterest rates and this shouldmean that government
bonds and high-qualityinvestment grade corporatebonds perform well. Asa bond fund manager,a weakening economicoutlook is actually goodnews for my asset class.Government bonds andinvestment-grade corporatebonds perform well in anenvironment of fallinginterest rates,” he says.
Long on duration, the M&Gfund is positioned to benefitfrom what Woolnough seesas the deterioratingeconomic outlook.
“The market is pricing inUK interest rates bottomingout at 4.25 per cent in mid2009, but I think there willbe more rate cuts than this,because UK interest rateswere at 4.5 per cent asrecently as June 2006 andthe economy now is ina much worse state now thanit was then,” he says.
Jupiter’s John Hamiltonalso favours the higher endof the investment-gradecorporate market over highyield and says there is astrong case to be made forthe attractions of investmentgrade corporate bonds at themoment, even in light ofcontinued volatility andissues hitting the market.
He notes that bond pricesare currently cheaper thanthey were during the 1998-2002 period, whichcontained the LTCM, Enronand Worldcom crises. Hesays: “It appears to me thatthere is a significant amountof forced selling going on,which is the result of certaininvestors – for example,banks, hedge funds –becoming overexposed tocredit via complex structuredproducts and now beingforced to reduce theirpositions. This is depressingvaluations and offeringopportunities for the longerterminvestor.
“That said, I am notexpecting a sudden bounceback, because conditions incredit markets will take sometime to recover, and it will bea slow process for banks torepair their balance sheets.”
As managers seek value incredit once again, it is worthscrutinising how managersare playing the currentenvironment. Directionalbond funds and those withabsolute return mandateshave the greatest flexibility intoday’s market but just howmany of them are using thisor are successful at it is worthseeing.
The highest onshore bondfund return over the pastthree months, according toLipper figures, is a gain of5 per cent, achieved bySchroder’s strategic bondportfolio, while the worst lossis 5 per cent, showing thedisparity in returns nowbeing seen in credit funds.

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