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Strategic thinking

Bonds continue to dominate sales even as equity markets move ahead and opportunities in fixed interest look less obvious. Spreads over Government debt have narrowed in recent weeks, lessening the blatant investment opportunity managers have been talking of for months. Considering the recent rally, is the story and opportunity in corporate bonds now over? Strategic bond managers certainly do not think so but while they are still favouring the investment end of the market, many are branching into other areas.

With the threat of inflation lurking in the background, some strategic bond managers believe the attractions of index-linked issues are growing. At the same time, the once deeply unloved bank bond area of the market is gaining strong attention.

Liontrust head of fixed income Simon Thorp and co-manager of the group’s forthcoming strategic bond fund says: “There has been a tsunami of money flooding long-only credit managers this year. This has helped push prices up and spreads down. Risk appetite is improving and the maturity of new deals coming to the primary market has pushed out from around three years back in November to seven to 10-year maturities.”

Amity sterling bond co-fund manager Chris Hiorns says: “Corporate spreads have come in, but there are still attractive yields on BBB and A-rated bonds.”

But while the majority of his portfolio is in investment-grade debt, he has been upping his weighting in other areas, such as index-linked. Index-linked are the only Government debt issues Hiorns owns in the fund as he believes the amount of gilt issuance makes it an unattractive area for investment right now.

“There are inflation concerns down the road. We would like to increase our exposure to index-linked and could even move it as high as 15 per cent, although I think it will be lower,” he notes.

Hiorns is not the only one drawn towards index-linked gilts. James Foster of Artemis’ strategic bond fund says index-linked paper is the only side of Government debt he is considering. But watching it is all he is doing for the time being.

He says: “Timing in this area will be difficult. It’s too early right now as RPI is negative and likely to be that way for the next couple of months.”

Another concern within the index-linked market is the amount of potential issuance. While there has not been a lot done with this area so far, if the Government perceives a demand, issuance will grow, he adds.

Thorp too is in the wait-and-see camp on index-linked gilts. There is no real sign of inflation yet but he predicts there will be an appetite for this part of the market shortly. “Almost certainly over the next couple of years, index-linked and floating-rate issues will play a larger role in people’s portfolios.”

He expects floating-rate notes will be one of the areas he looks towards once interest rates start to move back up.

For investing now, both Foster and Thorp are supporters of the bank bond sector of the corporate debt market. Recently topping up his positions in financials, Foster says: “Bank bonds will not be so adversely affected by changes in Government yields as other corporates. They have had a good run of late and I feel it has further to go.”

On an 18-month view, Thorp says there is further value to be gained from the bank sector and believes financials will outperform other corporates over that timescale.

Liquidity was an issue within bank bonds not so long ago and although Thorp and Foster say it has improved, it remains a concern. Foster, who is now benefiting from his existing weighting in this area, says there is an argument to be made for a Big Bang II – to have a central clearing house like the LSE for the bond market.

Hiorns is also involved in financials, buying select permanent interest buying shares (Pibs) and preference shares, giving these weightings of 13 and 8.6 per cent respectively in his fund. He says: “Pibs is a sector not without its problems but among the higher-quality building societies there are opportunities.”

Preference shares too can be considered at the riskier end of the market but, in sticking with the higher-quality insurers, he feels benefits can be had.

As with all areas of the market, there is still plenty to avoid in financials. Believing there is a clear delineation between the best and the worst, Foster steers clear of those he doesn’t think will survive for much longer, like some Irish banks. On the other hand, confidence continues to improve in the issuance from groups such as RBS and Lloyds.

Thorp, who is involved in lower and upper tier-two bank issues, notes several things have happened to bring value back to this section of the market. The part-nationalisation of banks helped restore some confidence and the level of spreads has undoubtedly been a draw for investors. At the same time, action from the FSA and the Turner review has meant there is little point in banks issuing new tier-two paper while also incentivising banks to want to buy back their own debt, creating demand while also slowing supply.

High yield within the strategic bond space is also getting attention, but it still lags the attractiveness of the lower investment grade. Thorp says that on a stock-specific basis there are good opportunities to be had. M&G optimal income manager Richard Woolnough has some 22 per cent of his portfolio in high-yield debt at the moment but remains heavily skewed towards the investment-grade end of the market with a 69 per cent weighting.

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