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Take a fixed view

As newsflow and sentiment change through economic and investment cycles, investor demand for different asset classes ebbs and flows. This, in turn, drives changing relative performance trends through the cycle. The credit crunch period since the summer of 2007 has been more extreme than the cycles of recent history but ultimately it has been no different in its influence on demand and performance.

The European high-yield market is a good example. From July 2007 to August 2008, the total return in this market was -8.5 per cent, or -7.4 per cent annualised (source Merrill Lynch, European currency 3 per cent constrained high-yield index). This illustrates the negative sentiment and risk aversion that typified the market at this time, including expectations of increasing default rates for bonds in the asset class.

The collapse of Lehman Brothers saw a very dramatic negative reaction in all risk markets and the afore-mentioned high-yield index fell by 25 per cent over September and October 2008, with high levels of uncertainty about world economies and government responses adding to the pre-existing fears.

Concerted central bank and government interven- tion has eventually led to an improvement in risk appetite and this, together with recognition that the market reaction had been too extreme and was discounting significantly greater levels of defaults than could be rationally expected, has seen a significant recovery in this market.

From the end of February 2009 to 22 July 2009, the European high-yield index has returned 37 per cent and recouped the negative performance seen in the second half of 2008. Other higher-risk areas of fixed income, such as emerging market bonds, have witnessed similar trends.

A comparison with the performance of European sovereign debt markets shows some of the other side of these trends. Performance of this market was 6.1 per cent from July 2007 to August 2008, or 5.2 per cent annualised (source Merrill Lynch ESOV index). In the rest of 2008 (September to end December), this market returned a further 6.7 per cent, most of this coming from price appreciation rather than carry.

The return to date in 2009 has been more muted at 2.5 per cent, as a result of credit quality concerns for some European sovereigns, investor concerns over medium-term inflation risks (which Threadneedle would argue to be overdone) and the volume of current and future government bond issuance.

Of equal importance has been the return of risk appetite to other asset classes and rotation away from lower-risk investments.

Rotational markets such as these cause headaches for asset allocators. However, a flexible fund, with the objective of making a positive return from the opportunities presented across fixed-income markets, can help.

Reduced uncertainty and lower levels of volatility will, in our opinion, continue to encourage investors back to funds that invest in risk assets in fixed income. At the moment, we see investment- grade credit as particularly attractive. This market continues to discount five-year default rates of between 6 and 8.5 per cent, depending on recovery value assumptions. This compares with a worst observation of less than 2.5 per cent in the last 40 years.

In summary, the breadth of the fixed-income market means there are opportunities throughout the investment cycle. However, this breadth can make it difficult for investors to time their asset-allocation moves within the bond universe. To make the most of the opportunities available, investors need to seek a manager with expertise in the specialist areas of fixed income and/or a fund that can nimbly move between asset classes.

William Frewen is head of fixed income at Threadneedle


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