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Sector Focus: Where to look for fixed income value

After a long period in the sun for bonds – a 30-year bull market, according to some commentators – the asset class is facing a tougher future.

Rising interest rates are the main factor in this and with returns from bonds harder to come by, more intelligent investing will be required to eke out performance.

With that in mind, strategic fixed-income products have been winning a growing market share, with freedom to look across the spectrum rather than being hostage to one particular area.

This is clear from IMA sales data last year: UK Corporate Bond was the worst-selling sector in the second and third quarters while strategic portfolios have continued to see inflows. Looking at top-performing strategic managers, many have made use of their broader mandate.

Leading the way over three years to mid-January – and more than doubling the sector average – is the Royal London Extra High Yield Bond fund run by Eric Holt.

According to Holt, the present pricing of corporate bonds is still attractive over the medium term, while their level of income generation is also appealing with the prospect of interest rates staying low short-term.

He says: “Economic conditions in the UK seem likely to remain challenging and, in these circumstances, we believe bond characteristics that mitigate risk – structural enhancements or a claim on assets or cashflows – are an especially important aspect underlying investment performance over the
medium term.”

For Holt, these characteristics are often underappreciated and are represented across several of his largest positions: one example is Premiertel, backed by properties on long-term lease to BT Group.

Financials remains a key exposure on the portfolio, reflecting the supportive environment, says Holt.

“Progressively tighter regulation, requiring proportionately greater levels of equity-type capital, is designed to reduce risk, in turn benefiting bondholders,” he says.

Major holdings in this part of the market include Phoenix Life and Yorkshire Building Society. Elsewhere among the top offerings is Artemis High Income, with flexibility to hold up to 20 per cent in equities.

Co-manager Adrian Gosden said the fund’s high-yield focus was key to performance in 2012 and 2013, with investors continuing to be attracted to the higher income stream than available elsewhere.

“Looking into 2014, particularly after such a strong 12 months, our focus is always on the coupon initially and after delivering that to investors, we can look to capital growth,” he says.

“We would highlight some positives in the market, with M&A activity starting to pick up, for example. If you own a bond where the company is acquired by a better-quality operation, the debt will go up in value. 

“Likewise, if you own debt in a business that IPOs, the new equity cushion makes the bonds more valuable. For us, these are both potential levers for returns this year beyond the basic coupon.”

That said, Gosden and co-manager Adrian Frost acknowledge deteriorating value across the bond spectrum, with much of the fund’s recent performance coming from deeply discounted names coming back. Pearl debt has climbed back to 80p, for example, having dropped to 10p at the worst of the crisis.

“The strong performance from some of the fund’s comeback kids should be regarded as a victory lap,” adds Gosden.

“Unlike equities, par value is where a bond both begins and ends its life. At present, there are very few opportunities that can offer the prospect of anything like the returns these bonds have given over the last two years.

“But in an inflationary environment, we feel our portfolio is less vulnerable than so-called safe government bonds, which, at current valuations, may actually be regarded as risky assets.”

Like many of his peers, Jupiter Strategic Bond manager Ariel Bezalel says the Federal Reserve’s tapering programme is the key macro development for fixed income this year.

He says: “The lower-for-longer tone to the Fed’s forward rate projections was also positive. It underscored [central bankers’] belief the economic recovery still has some way to go and affirmed the Fed’s desire not to let go of the yield curve and cause undue weakness in the economy and markets.”

Overall, Bezalel remains optimistic about the outlook for credit in 2014, with a bullish case that the economic data broadly meets expectations and the market factors in an orderly tapering process.

He says: “Under this scenario, we believe there is potential for high-yield bonds to produce decent returns but we remain mindful the Fed faces a formidable task.”

Bezalel continues to see compelling opportunities in European high-yield.

“The region is enjoying low default rates, companies continue to focus on repairing balance sheets, the economic backdrop is stabilising and interest rates are likely to remain low for a prolonged period. These conditions contrast with those in the US where companies are more confident and so more willing to take on leverage.

He says:  “In terms of specific sector opportunities, banks are in the midst of a multi-year deleveraging process that could see them revert to utility-style businesses in the world of fixed income. Other areas of interest include oil rig financing, debt recovery businesses and pub securitisation.”

Bezalel warns against complacency, however, and is working hard to manage risks associated with changing interest rate expectations as well as keeping duration low.

M&G’s Richard Woolnough, another strong performer in the sector with the massive Optimal Income fund, also remains positive on credit, buying a significant amount of the record-breaking $49bn deal from Verizon in September for example.

He says: “Verizon’s 30-year bonds were priced to yield around 6.7 per cent, nearly 3 per cent above Treasuries, which looked very attractive for a solid BBB rated credit.”

In the following months, he swapped out of the group’s 20-year bonds into those maturing in 10 years as the longer-dated bonds paper performed well and offers negligible spread pick-up.

Elsewhere, he has continued to lengthen the fund’s duration in response to rising yields while retaining its overall short duration versus a neutral position of 5.5 years.

Optimal Income’s duration rose from 3.2 to 3.6 years in December, a year higher than where it ended 2012.

“The move reflects the increased value rising yields have brought but we expect they will rise further in the medium term – albeit at a more moderate rate than in recent months – which explains overall short position,” adds Woolnough.

Best and worst performing sterling strategic bond funds over three years
Top five  funds Total return to 30/01/14
Royal London Sterling Extra Yield Bond 41.3
Artemis High Income 35.8
PFS TwentyFour Dynamic Bond 31.4
Baillie Gifford Corporate Bond 31.1
Pimco GIS UK Sterling Long Average Duration 30.2
Bottom five funds  
M&G UK Inflation Linked Corporate Bond 11.8
Rothschild RPIC Preferred Income 9.2
JPM Strategic Bond 9.1
Pimco GIS UK Sterling Low Average Duration 7
Investec Strategic Bond 3.8
Figures are for total returns on a bid to bid basis for the three years to 30/01/14
Source: FE Analytics  



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