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The bond plays on

Many investors are questioning whether corporate bonds are still an attractive investment, with global interest rates rising and credit spreads close to historical lows. Significant changes in the market over the last 10 to 15 years mean the answer is not as black and white as it may have been a decade ago.

In particular, the introduction of the Ucits III directive has brought more scope for the use of derivatives. Managers are not obliged to use the new tools but we believe many fixed-income managers will embrace the changes. We are already seeing a number of developments – the launch of funds using the new powers, portfolio manager moves triggered by mutual fund companies having a more attractive environment in which to run these types of funds and non-retail players entering the retail market with Ucits III versions of existing hedge fund approaches.

It is particularly interesting to note the growth of the credit default swap market, which now rivals the cash market in size. CDSs are available for the majority of big, liquid credits in the investment-grade and high-yield markets globally. The most obvious buyers are investors with direct exposure to corporate bonds looking for protection against default risk or some other credit event associated with the issuer of a bond in their portfolio. They are also being used by investors without exposure to physical bonds to manage their expectations for the credit market. CDS index products, such as iTraxx, can be used to provide exposure to the direction of the market as a whole. More generally, derivatives can be used to target more precisely the risks embedded in a bond, such as currency or interest rate risk.

This last point on interest rate risk is quite interesting. In corporate bond land, it is often noted that duration can dominate returns. Many traditional bond managers have chosen to manage this risk in relative terms, versus an index or their peer group. However, now interest rates are rising around the world, it is a different story. Ucits III can overcome this as it allows more of an absolute or total return approach and, as interest rate volatility picks up, managers will find more opportunities.

For those managers with the resources and skills to use these instruments, they offer the potential not just for higher returns but also reduced cyclicality as spread widening can be exploited to generate absolute returns. With credit spreads at historically tight levels and concern being voiced that they will widen in the medium term, corporate bonds can remain an attractive part of a portfolio.

Simon Mungali is a multi-manager fixed income analyst and portfolio manager at Fidelity

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