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The peas corps

In my last article, I outlined some of the features of different classes of Government bonds and corporate bonds. I concentrated particularly on projections of investment returns from investment funds holding each of these classes, noting their performance in recent years and the sources of information which might guide our thoughts as to future trends.

Before moving on to the much less complex asset class of cash, in this article I will give a few examples of funds which fall into each of the main categories of fixed-interest fund.

First, it is important to be aware that the ABI categor- isations divide fixed funds between UK gilts and UK fixed interest. The former are restricted to investing in UK gilts while the latter can invest solely in corporate bonds or divide their investments in any proportion between corporate bonds and UK or overseas gilts.

As regards the UK gilt sector, average returns from funds over the past 12 months have been around 7 per cent. Although by no means match- ing returns from property funds and equity funds, this is clearly a respectable performance which is due largely to the continuing fall (albeit slight) in long-term interest rates, which has a positive effect on the market prices of fixed-interest investments.

Most important, for the purposes of this series of articles, I would like to highlight the fact that the worst-performing fund in this sector produced returns over this period of a little over 5 per cent while the best-performing funds returned 9 per cent. I would suggest it should be obvious that the variance between these two extremes is relatively small, especially noting that a significant majority of funds in this sector produced returns within half a percentage point of the average.

I explained the reason for this lack of variance in my last article as being due to the fact that every gilt issue over every redemption term currently offers almost identical redemption yields so that fund managers inevitably struggle to differentiate their funds from all the others in the sector. Indeed, irreverent observers might facetiously speculate as to the reason why any fund provider might pay extortionate wages to fund managers in this sector.

More seriously, though, over that same 12-month period, it is noticeable that medium- to longer-dated gilts have significantly out-performed shorter-dated gilts, that is, those with less than five years to redemption, indicating that funds investing in those longer-dated gilts should have outperformed funds investing in shorter-dated issues. This issue is the most salient factor in determining the relative performance of funds over that period.

On then to the fixed-interest sector which, as I have noted already, includes funds which may invest in the range of fixed-interest investments. This includes funds which are mostly gilt-based, with relatively few holdings in corporate bonds, through to those which are invested entirely or almost entirely in these instruments.

In this sector, the range of fund performances is far wider than the gilt sector. The average return over the past 12 months has been around 8 per cent (1 per cent higher than the gilt sector) but the variance between performances is around 10 per cent compared with only 4 per cent in the gilt sector. Why such a wide variance? Take a few funds as examples. Fund A, a moderately-performing fund, is a gilt and fixed-interest fund which over the past 12 months has typically been invested almost 50 per cent in gilts, with the remaining holdings consisting of high-investment-grade corporate bonds with a minimum credit rating of A.

These quality holdings have very little history of downgradings, let alone default, so the investor should be quite confident that what you see is what you get. The current anticipated income yield on the fund’s assets, after charges, is stated by the fund managers to be 3.5 per cent. As I noted in my last article, this is entirely predictable as an amalgamation of a typical 4.25 per cent on gilt holdings and 4.75 per cent on high-grade corporate bond holdings, less charges.

Fund B, by comparison, has achieved a performance over the last 12 months of 11 per cent, which is well over the sector average. This could not have been achieved by funds with a large holding in gilts which, as we have already discussed, have invariably returned between 5 and 9 per cent, so it should come as no surprise that this fund invests entirely in corporate bonds. Moreover, on even a small amount of further investigation into the management strategy of the fund, it can be noted that the bond holdings within the fund are actively traded, with a division between invest- ment-grade and sub-investment grade bonds.

This strategy has worked in this fund’s favour not only over the last 12 months but over the previous year, when it again finished in the top quartile of its sector. However, two years ago (that is, in the year to mid-2003), this fund was one of only a small number in the sector which produced a loss for investors, putting it firmly in the bottom quartile.

The published anticipated yield on this fund is 5 per cent which, again, is entirely predictable as the typical yields on this range of corporate bonds varies between 4.5 and 6.5 per cent before fund charges. This is a typical example of a fund which, as in most other sectors, investors could even expect to be highly volatile. When the specialist nature of the fund strategy and management work well in conjunction with favourable market condition,s this type of fund should outperform its sector.

Conversely, of course, where a particular strategy works less well, especially in less favourable market conditions, this type of fund might be highly likely to feature in or around the bottom quartile of funds in its sector.

So, it is possible to make some summary suggestions about the factors which should or might feature in a process of selecting preferred funds in the fixed-interest sector.

As regards gilt funds, I would suggest that, with so little variation between redemption yields on all fixed-interest gilts, differentiating between potential returns is very difficult. True, certain fund managers seem to be able to outperform the sector average more often than not, though usually not by a very big amount. Note also that there are different redemption terms. But, overall, the differences are not as pronounced as those between funds in other asset classes and sectors.

Corporate bond funds require more consideration, with factors including the range and weighting between different grades of corporate bond insurers, the range of redemption terms and the number of different bond issues held within the fund.

As regards this last point, it is worth noting that the lower the number of holdings, the higher will be the susceptibility to volatility, as the risk of individual downgrades or the benefit of individual upgrades will have a more pronounced effect on the overall performance of the fund.

Finally, and very importantly, returns from fixed-interest investments have historically been lowly correlated with property funds. This means that combining property and fixed-interest funds in the same portfolio should reduce overall portfolio risk significantly.

In my next article, I will expand this consideration of overall portfolio performance and volatility by adding equities into the equation. This will therefore continue building the following summary grids:


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