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Special effect

What a difference a day makes. Since March 17, the day the markets digested the news of the Federal Reserve’s intervention in the Bear Stearns situation, the FTSE All Share is up by almost 15 per cent. The European high-yield market has risen by some 7 per cent. Even the financials heavy iBoxx Sterling Corporates index is up by about 2 per cent. This experience highlights the difficulty of calling the bottom of markets. It has also prompted managers of funds in the IMA UK corporate bond sector to make the case for value in sterling credit.

Certainly, the past few weeks have seen a degree of normalisation in credit risk premia but it is dangerous to associate this with improving credit fundamentals.

Historically, spreads have not peaked until shortly before the peak in default rates. These have only recently started to increase from record lows and are likely to continue to do so as economic activity declines and corporate finance becomes harder as the credit bubble deflates. It may take longer than in previous cycles for defaults to peak, since the long period of easy money has allowed many corporates to enter this downturn on extra borrowed time.

It is paramount to think about stock-specific risk in corporate bonds, not just the general attractiveness of credit spreads. Sometimes the opportunity arises to buy good quality bonds trading erroneously at distressed prices but the key manoeuvre is to separate the good quality bonds from the bonds that actually deserve to be trading there.

As a result, although we are running a full weight to corporate bonds, both investment grade and high yield, we own no funds in our portfolios which reside in the IMA UK corporate bond sector. The average fund in the sector has underperformed the iBoxx Sterling Corporates index by about 2.5 per cent a year over the past 10 years, suggesting a degree of value destruction, even allowing for the high standard management fees on these funds.

Our approach is to look beyond the obvi-ous retail funds to the institutional boutique fixed-income managers. Here we find long-evity of experience, well resourced teams not burdened by the weight of their assets, charg-ing reasonable fees. They tend to be special-ists in particular parts of the global fixed-income markets. We believe we can achieve a superior result by building a portfolio around these specialist funds rather than making blunt asset allocation calls to the market as whole. We expect the funds we own to take advantage of current opportunities, producing good medium-term results.

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