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To B or not to B?

Whatever measure of inflation you use, it is unarguable that we are in a low-inflation environment.

Hand in hand with that go low interest rates and, regardless of whether another quarter-point rise is on the cards in May, a base rate below 6 per cent is low when you look at the past 30 years.

With such a low level of interest available, income-seekers are having a difficult time at present. Bank accounts pay base rate but no more while equity income funds pay 3.5 per cent.

The lure of a structured product is always in the back of investors’ minds although they should probably be resisted, leaving only corporate bond funds to provide the possibility of any decent or reasonable level of income.

As always, there is a however. For those seeking steady, secure income and not too much risk, then an investment-grade corporate bond fund is probably suitable as long as you are prepared for an income level of only 5 per cent or thereabouts.

I have to ask is it worth going for an investment-grade bond fund yielding 5 per cent when you can get that in a bank account? I am not convinced.

If you rule out investment-grade funds, that leaves you with high yield paying in the region of 7 per cent but with the capital possibly at risk if the economy suddenly takes a nosedive. Not really much choice is there?

Well there is. There are some bond funds, normally with the moniker “strategic”, that aim to move around the credit and duration scale, seeking a total return in excess of investment grade and more consistency than high yield. One such fund is the Cazenove strategic bond fund.

This is a relatively small fund at £120m, forming part of a total of £550m in funds that the Cazenove bond team manages. This does not make it a huge player in the UK market but what the four-man team headed by Peter Harvey lacks in size, it more than makes up for in experience and focus.

This fund is taking an absolute return approach rather than targeting a specific yield, with the emphasis on avoiding the losers that can so damage a corporate bond fund’s performance.

To achieve this absolute return approach, this fund has been set up as a Ucits III vehicle, which not only enables traditional bonds to be bought but also allows Harvey the flexibility of effectively going short if he feels conditions are particularly bearish.

He can make money while all others around him lose their heads.

Harvey is using the resources of the Cazenove pan-European equity team to get a wider perspective of a particular company, taking account of the equity team’s outlook for the company when buying its bonds.

If the bonds look sufficiently attractive but the outlook for the company is not so rosy, then he will buy the bond but can also buy a hedge against it defaulting.

If all goes well with the company, then the bond continues to pay the coupon and investors in the Cazenove fund are happy. However, if things start to go slightly awry, then the fact that he has bought a hedge against default means that any loss in either capital or income is then made up. This hedge generally costs about 0.3 per cent.

Obviously, if the bond never defaults, that 0.3 per cent has been wasted.

By focusing on B to BBB-rated bonds, Harvey manages to generate a higher level of income but reduces the risk profile by using the hedging strategy.

Essentially, what Harvey and the team are trying to do is achieve their return by playing the credit markets and through bottom-up stock selection.

They are not interested in gambling on duration or even taking interest rate bets. They are taking an equity-like approach to their bond picks and believe that understanding management attitude to risks is important.

They believe in their own fundamental research and have their own Cazenove capital ratings for bonds rather than relying on S&P or Moody’s as many other managers do.

With a benchmark of cash plus 2.75 per cent a year, this fund, if it can deliver, and other strategic-style bond funds could become the norm in the coming few years.

The fund currently yields 6 per cent. It does not completely answer my initial question about achieving a higher level of income as it will be run on a total-return basis, which means the income could fluctuate,

However, Harvey is still conscious about the need for consistency where practical.

I, for one, will be watching this closely as I have a feeling that this fund could do very well.

Ben Yearsley is senior investment manager at Hargreaves Lansdown.

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