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Match of the day

Considering more than half of net inflows into funds are headed into fixed-interest sectors at the moment, investors should be aware that the nature of bond funds is undergoing a change and may need to adjust their expectations and approaches.

The high yields available in the investment-grade sector have been a big draw for income-seeking investors, with around 50 per cent of all net inflows from Cofunds so far this year headed towards the sterling corporate sector, according to the firm’s fund manager relations director Russell Lancaster.

This type of attention paid to a single asset class generally brings up the question of a potential bubble but bond managers say the market is a long way off such an event. This is an expected response but it does have validity.

Rather than fearing a potential bubble, there are more immediate considerations that advisers should be aware of when recommending bond sectors in the current market environment – ones that have not traditionally played that big a role in fund selection.

The illiquidity in the secondary bond market has been well publicised but is often believed to only be affecting the troubled bank and financials sectors. In fact, across the board, it is more difficult today for a fund manager to trade a bond before it matures. Spreads on secondary bond issues have widened significantly and while the top blue-chip names may be able find a buyer, it is not as easy as it once was. Traditional bond buyers have left the market – hedge funds and investment banks – and they are not expected to return any time soon.

Western Asset Management head of international business Mike Zelouf, says managers have to adopt a different investment strategy in this changed environment, with more bond matches taking place than buying and selling.

He says: “Funds looking to trade existing holdings will struggle in the shrinking secondary market and are likely to adopt a greater buy and hold strategy over trading. Managers are likely to show preference for shorter- duration bonds, holding them to maturity rather than selling them into the secondary market.”

He believes investors should also gravitate towards a more buy and hold attitude than trading funds.

Aegon high-yield manager Philip Milburn agrees that illiquidity is leading to an increase in the timescale for managers.

Speaking at a recent Cofunds income round table, he said: “The time horizon for holdings has dramatically extended because of volatility and lack of liquidity. Liquidity is a coward, it runs away in times of stress. These days, you can not churn and burn a fund. If I am interested in a company’s debt, I have to think, do I still want to be holding that debt in two to three years time?”

As timescales grow longer, durations within funds are expected to get shorter to enable managers to keep holdings until maturity. Zelouf believes the changes happening in the bond markets will place both pressure and value on active fund management. With the widening of spreads on individual issues, transaction costs will affect performance, making it difficult for managers to compete with indices.

Rathbones corporate bond fund manager Bryn Jones says: “Trading on valuation differences has become very difficult as bid/offer spreads are very wide and make the cost outweigh the benefits of doing the transactions.”

Just as managers change the way they are managing their debt holdings, so too must investors adjust their expectations and understanding of what is happening within their fixed interest holdings.

In the main, investors have looked at the sterling corporate and high-yield markets as a way to get a combination of income plus capital appreciation. These days, the high-income streams available are not yet being accompanied by much, if any, capital uplift. Over 12 months to March 14, 2009, just 11 funds out of 86 achieved positive returns in the sterling corporate bond sector, with the average falling by 10.6 per cent, according to Trustnet figures. Not a single fund in the sterling high-yield sector gained over the 12 months to March 14, although nine out of 17 funds managed it over the shorter three-month period to the same end date.

Yet the yields in these sectors are impressively high, despite the capital falls which have dragged down total returns. Within the high-yield sector, the variance in yields runs from a high of 25.19 per cent to 4.84 per cent while in the corporate bond peer group the yields range to a high of 9.8 per cent, with just 19 out of 86 funds yielding less than 5 per cent.

Zelouf says that perhaps investors need to reconsider the capital aspects of bond investing and start to look at bond portfolios as more income-focused vehicles.

Jones says capital appreciation is starting to make a comeback in the bond arena. “We can see pockets of performance from gilt yields falling and spread contraction. As for financials, these continue to struggle and the hope of investment banks posting some half-decent earnings in Q1, the hope that toxic protection schemes may halt anymore significant writedowns and a return of confidence in the sector will help capital appreciation in the financials’ space which makes up a large portion of debt markets.”

Zelouf says there could be a greater chance of capital appreciation in the high-yield sector and Milburn agrees, saying that, on a total return basis, the high available yields can push funds into positive territory but he concedes there is still heightened default risk in the sector.


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