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Quantum of solace for bonds

This year is shaping up to be ghastly for stockmarkets. Yet with all falls, opportunities do arise and this is the case with corporate bonds. Indeed, Stephen Snowden of Old Mutual is so confident that he has put a considerable amount of his own money into his fund.

The economic downturn is set to continue for quite some time as we wait for the deleveraging process to play out but this in itself is deflationary rather than inflationary and here lies the opportunity for bonds.

The trouble is that the downturn will feed all the way through the supply chain. It does not just affect the construction workers but also the furniture makers and removal firms. A falling housing market has profound implications for the UK economy.

In a normal downturn, you would expect interest rates to fall to help boost the economy. However, the Bank of England’s remit of 2 per cent inflation is stopping it doing this for the time being. That said, interest rates have effectively been going up anyway for those who have got a mortgage and remortgagers are finding that the real cost of borrowing is much higher than the base rate would imply.

Despite this doom and gloom, there are opportunities both in equities and bonds and this week I shall concentrate on corporate bonds.

Old Mutual’s corporate bond fund managed by Snowden invests in investment-grade bonds which are borrowings from companies rather than governments. Not only have these suffered on the back of inflationary expectations but also due to the credit crunch.

Financial institutions have been forced to sell bonds to raise cash for their balance sheets. As with any market with forced sellers, bargains start to appear quite quickly as those desperate to sell have to take whatever price they can get.

This has probably thrown up one of the best opportunities to buy bonds for many, many years. Indeed, Snowden reckons that if you do not buy them now, you never will.

He believes (rightly, in my opinion) that the fall in demand that we are experiencing in the UK, the US and Western Europe will in itself lead to low inflation in the future. Remember that filling up your car, buying food and paying the utility bills is all sucking money out of your pockets.

In a strange way, these rising prices are actually deflationary in that we have less money to spend in the shops and this should keep prices for all non-food and non-energy purchases low. This would give the Bank of England an opportunity to reduce base rates. Ideally, these should be much closer to 4 per cent in the current environment instead of their current 5 per cent.

Compared with the last recession in the early 1990s, most workers are now not in the position to ask for higher wages. Perhaps the only exception is the public sector, which seems to think it is immune from the economic problems and can hold us all to ransom. However, if the Government has the courage to hold the line on wage increases, interest rates are more likely to start falling next year.

Snowden believes that banks have still not revealed the true extent of their losses and that more horrors will come through. The sooner that happens, the better and perhaps by the end of the year everything will have come out of the woodwork. Only then will the banks feel more comfortable about lending to each other, something we desperately need to help grease the wheels of the economy.

Where does that leave the fund? It currently has a yield of 7.5 per cent, which looks remarkably good, considering the prospect of some capital growth on the underlying bonds as well. I have not been a bond fan for many years but I really think there is an opportunity in this asset class and with this fund in particular. Remember, too, that when the fund is held in an Isa or Sipp, the income is tax-free.

Snowden is the man who said a few years ago that investors would be better off in cash than in bonds in the short term. I doubt that Old Mutual’s marketing department was very happy about that but his honesty was proved right. He is far more bullish now and I believe he will be proved right once again.

Mark Dampier is head of research at Hargreaves Lansdown

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