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Selection process

Now is the worst time for big macro calls in fixed income. Instead, we are in an environment where stock selection will be absolutely crucial. The economy is practically at the moment of peak uncertainty and it is nigh-on impossible to see clear macro trends.

Uncertainty has been building for some time. Both deflation and inflation remain a risk, little of the G20 bailout money is aimed directly at preventing corporate failure and quantitative easing is yet to have a substantial positive effect on corporate bond markets.

In a flat market, big calls on, say, interest rates can boost performance. Now they are more likely to add additional risk that simply is not worth taking.

Instead, with such an attractive income to be gained from corporate bonds, investors would do much better by choosing a stock selection approach that aims to carefully weed out the bad bonds from the good.

In essence, corporate bond markets are polarised into financials and the rest. We all know the former has underperformed drastically and as the economy worsens, the banking system has to take this pain.

There are many distressed bank bonds which even the most cautious investors should take a look at. However, in this market, choosing where within a bank’s capital structure you invest is just as important as getting the names right.

For example, I have gained more conviction about deeply subordinated bank debt recently. The risk is that if the Government takes further stakes in banks, subordinated debt may continue to underperform. I think this is a highly unlikely prospect and I am looking at the bonds more on a value basis.

Any investor with the liquidity to do so would have done well in lower tier two bonds (which are the next safest to senior debt) when they rallied back up to 90p in the pound. They, like me, may have taken these profits and focused then on some positions in upper tier two debt, where prices have stayed at lower levels.

Outside of banks and financials, there is an almost unprecedented spectrum of returns. Eighteen months ago, one percentage point separated the best and worst-performing BBB-rated bonds. Now it is more like 10 points, which could suggest that analysing bonds, meeting company management and building a diversified portfolio of credits is as much as 10 times more important than before. Divergence of returns of the bonds within sectors illustrates this well.

If we take total returns over the past few years, telecoms, energy and consumer cyclicals did the best, gaining about 10 per cent.

However, if we look at telecoms, we find that BT bonds priced anywhere between around 71p and over 102p.

At the other end of the spectrum, it is not just in financials where investors could find attractive distressed bonds. Pub Group Enterprise Inns has a BBB- rated bond that yields 21.1 per cent and is priced at around 40p.

Despite such an (at least in the near 25 years I have managed bond funds) unusually uncertain economic background, investors can still obtain handsome returns. The sterling corporate bond market as a whole pays a redemption yield of around 9 per cent.

However, as bonds get downgraded and then potentially default, I believe that an approach of careful research, prudent stock selection and diversification is more likely to be of benefit to investors than one which makes big macro calls.

Ian Spreadbury is portfolio manager of the MoneyBuilder income fund at Fidelity International

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