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Road to redemption

Bonds have an inbuilt ability to sidestep market calamities and recover lost ground

There has been a higher than anticipated decline in economic activity and future expectations but not quite enough to tip Japan, Switz-erland, Germany, the US and the UK into a full recession.

The core bond market response, as seen in bond futures, has been excessive, pushing interest rate expectations for the above countries to extremely low levels for many quarters to come.

With the exception of Japan, inflation and inflation expectations have been sticky, not declining as much as some central bankers hoped. This combination of low bond yields and stubborn inflation creates unappealing prospective real yields.

Conversely, the extent of credit spread widening, especially in single name credit default swaps, has not been as aggressive as might have been expected, given macro fears and equity market swoons. The JB absolute return funds are built to withstand a major calamity. What we have seen so far is a change in relative bond prices.

However, there is a bright side to these market moves, courtesy of the key attribute of bonds – the pull to redemp-tion. If the incidence of actual defaults remains as low as it is now, it is likely the bonds will recover that lost ground and boost future returns. If there is an increased incidence of defaults, JB absolute return funds are well positioned to protect from such calamitous events and could even benefit from them.

The current market feels like the fourth quarter of 2008 but at about one-third of the intensity. At that time, the JB absolute return funds, like many others with credit positions, suffered before retracing much more than the ground lost within six months.

To profit, not just recover, from the current unexpected turn of events, funds need to capture the twin reconver-gence themes, first within European government debt and second between corporate bonds and underlying gov-ernment bonds, that have been surprisingly re-offered to us.

This will entail accurate timing of the switch out of expensive core government paper into beaten-up bonds.

Two bits of good bond news in the gloom are Autonomy 3 per cent due 2015 convert-ible bonds and Bank of America bonds. The bid by HP has pushed the Autonomy bonds up by 43 per cent in price terms and the $5bn investment by Berkshire Hathaway into Bank of America preferred shares has renewed buying interest in Bank of America bonds.

We have not made any big portfolio changes. On the government bond front, we have cut short-dated US Treasury inflation-protected securities, sold short interest rate futures in Australia and Canada, established bearish trades in German debt via options and sold some long bond futures in the US.

Modest changes of the non-government side include reducing the equity hedge on our convertible bond strat-egies as equity index levels have declined, profit-taking on selected credit default swap widening and the addition of value trades such as HSBC senior Yankee debt at Libor plus 175 and further Bank of America debt at Libor plus 450.

We have also added more credit protection in US commercial mortgages as well as purchasing US non-agency mortgage-backed securities.

Tim Haywood is co-fund manager of the JB absolute return bond, absolute return bond plus and absolute return bond defender at Swiss and Global

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