It is easy to put a case forward for fixed income. The usual factors apply, such as low cash rates, equity market uncertainty and investor appetite for income, but it is up to intermediaries to highlight the accompanying risks. And let us not kid ourselves that these are negligible – if the base rate is 0.5%, and the yield on a corporate bond fund is 5%, then the fund manager must be making big calls somewhere down the line.
As it stands, fixed income, in particular corporate and strategic bond funds, has experienced another wave in popularity. According to the latest IMA figures, Q1 this year represented the best quarter for fixed income funds since Q3 2010 – bonds have been the leading asset class for seven consecutive months with net retail sales of £660m in March.
Gradual shift
John Husselbee, chief executive at North Investment Partners, says he is surprised by the extent of the wall of money that has gone into credit, though he identifies a “gradual and continuing shift” towards income.
“We have had a trendless market and therefore people are looking for certainty; the one thing that provides certainty is income,” he remarks.
However, he believes that investors would have been better off keeping their money in cash or waiting for better buying opportunities in other credit types.
“With the start of this year, the thirst for credit was quite explosive, but by February you probably had half or even most of the return you are going to get from corporate bonds,” he adds.
Pause for breath
“By the way that spreads have narrowed, there has to be a pause for breath, and we have seen that. I think that perhaps those buying in the past couple of months have been buying things which are at the upper end of price. That is what has surprised me from those numbers, that there are people prepared still to buy bonds at any price.”
For his part, Husselbee prefers the greater security of short-dated credit funds from the likes of Muzinich & Co, which fields Short Duration High Yield Bond Fund.
Muzinich’s institutional sales director, Josh Hughes, sees the fund as a middle ground in the high yield sector that delivers returns above government bonds and investment grade, but with less duration risk than longer-dated alternatives.
He adds: “Default rates are the biggest consideration for any high yield investor and, while the implied default rate has risen a touch lately, defaults will remain below historic averages in our view and in our own portfolios we expect to avoid them altogether, so the case for high yield and short duration remains compelling.”
The Sterling Strategic Bond sector has experienced a huge rise in popularity in recent years – funds under management totalled £24.6bn in March, more than double the £11bn held in these products three years earlier. The greater flexibility of these funds to invest across the fixed income spectrum is an obvious advantage.
Go anywhere funds such as Ian Spreadbury’s Fidelity MoneyBuilder Income and Jupiter Strategic Bond Fund – where manager Ariel Bezalel currently has high exposure to Australian government debt – are among the popular options.
Hidden dangers
Graham Duce, co-head of multi-manager funds at Aberdeen Asset Management, is a keen user of strategic bond funds alongside traditional corporate bond vehicles. However, he warns investors not to be complacent.
“There is a danger when people invest on yield, and they need to understand why a fund yields such a relatively high number vis-à-vis cash on deposit because there is credit risk,” he says.
“Investors have to be careful because some of the products available to IFAs in the fixed income world are very complicated.
“For example, L&G Dynamic Bond Trust has a lot of moving parts in terms of how he [manager Richard Hodges] spends his risk budget, and how he uses CDS in the portfolio. That is quite a sophisticated offering.”
Getting it wrong
Increased sophistication of funds is one thing, but the more customary risk of a fund manager simply getting it wrong with a bad call is also a more heightened danger in fixed income at present, particularly given ongoing concerns about liquidity and the sovereign debt crisis.
In its ongoing research into fixed income funds, S&P Capital IQ highlights a divergence of opinion among managers as to where value lies, especially over the past 12 months.
Linda-Jane Coffin, director of fund research, picks out financials as a key area where the outlook differs. In particular, two giants of the corporate bond world, Invesco Perpetual’s Paul Causer and Paul Read, are singled out as having a tough time with their funds’ exposure to subordinated bank debt, including the flagship £5.6bn Corporate Bond Fund.
This contributed to a relatively poor showing from the fund in 2011 – in the second half of the year, its total return was -5%, compared to a 2% rise from the peer group average. S&P subsequently downgraded the fund from a Platinum to a Gold rating.
Too big to fail
“The immediate investment observation was the high exposure to tier-one subordinated debt issues, and their view was that some of the banks, particularly the French and UK banks, were too big to be allowed to fail,” says Coffin.
“At one stage 23% of the portfolio was invested in this area; the fund managers’ view was that they would be upgraded or redeemed or called over in the next few years as Basel III’s regulations would be implemented.
“We had a number of concerns, the main one being the illiquidity it brought to the portfolios that they were managing, with nearly a quarter of the portfolios invested in that area. If they had a big redemption, they would not be able to realise that easily.”
Bearish position
In contrast to the Invesco team, Chris Bowie, head of credit at Ignis Asset Management, is underweight banks, especially European entities such as Deutsche Bank, Santander and Crédit Agricole, though he does hold issues from HSBC and Standard Chartered, British banks with a global footprint that did not need to be bailed out.
“We are pretty bearish on the outlook for sovereigns in the eurozone, and therefore it is very hard to have an optimistic stance on banking credit,” he explains.
“The only thing we have added to banks in the past year is covered bonds, but this plays very much into a strategy we have elsewhere in the fund, which is that we like secured bonds where you have physical assets backing the cash flows.”
Secured bonds are, explains Bowie, a relatively new concept in the UK market. As the cost of funding for subordinated and senior debt has risen, banks have looked for a cheaper source of funding and so have securitised, ring-fenced and packaged off their mortgage assets to the bond market.
A defensively-positioned Bowie also favours secured credit in other parts of his Ignis Corporate Bond Fund, such as in utilities and the major UK supermarkets (Tesco and Sainsbury’s).
The window closes
Ignis has recently launched the Absolute Return Credit Fund for Bowie, a sign perhaps that the group predicts tougher times ahead for the sector. The manager himself says he worries that the best opportunities may have passed.
He remarks: “Investors at the back of their minds think bonds are less volatile than equities, therefore as they worry about equities and get nothing from the bank they go for corporate bonds instead. But what worries me is that government bond yields could be quite volatile over the next few years.”
“2009 was best time to buy. I said at the time that it was an once-in-a-lifetime opportunity. But at some point over the next year you will want to get out of fixed rate bonds. With inflation at 3% or 4%, depending on how you measure it, and ten-year yields at 1.9% there is not much upside left on the table.”
