Last year was an excellent time for investors in credit, as corporate bonds yields came down from their unprecedented highs, delivering significant capital gains. Governments around the world stepped in with stimulus packages to get their economies growing again.
In 2010, this economic recovery has continued - albeit with a certain amount of market volatility, thanks to the concern about sovereign debt caused by the financial situation in Greece.
However, the gradual improvement in various economies and extremely strong returns from corporate bonds in 2009 should not imply that corporate bonds have had their day. Corporate bond spreads - the extra yield offered by corporate bonds over government bonds - have retraced from their extreme depression-style levels of early 2009. But, Richard Woolnough, award-winning retail fixed interest fund manager at M&G, believes that there is still room for them to tighten further - just one of the reasons why he thinks that corporate bonds remain attractive. In Richard's view, supply dynamics in the bond markets are likely to be a powerful driver of performance going forward. Many companies are refinancing their businesses through the capital markets rather than the banks, which have effectively been cut off to them as a source of funding. So supply of corporate bonds has been very high in the past year or so. However, Richard believes this is a one-off shift and while the supply of government debt will remain high, it should gradually decline in the corporate market, helping spreads grind still tighter.
In addition, with interest rates at historic lows, and likely to remain very low for some time, they are also still offering compelling yields relative to cash. Although there is default risk with corporate bonds, Richard thinks that company defaults are unlikely to rise to the level that is being priced in by the market - in fact, defaults have probably already peaked.
Returns from fixed interest do not come just from taking on credit risk - they are a combination of credit and duration (the latter being the sensitivity of bonds to changes in yield). While it was sensible to remain short duration through much of 2009 while gilt yields were rising, Richard believes duration is now becoming more attractive. This is because the difference between longer-dated yields and short-dated yield is the largest it has been for many years. Richard therefore believes that investors are again being paid to take duration risk, and he has been increasing the duration of his funds in recent months as a result.
Richard's outlook for the rest of 2010
Richard Woolnough believes that the recent jump in inflation numbers is likely to be merely a temporary phenomenon and not a structural shift to a higher-inflation environment. It is his expectation that we are likely to experience low inflation and low interest rates for some time. Due to high levels of unemployment around the world, wage costs are not likely to cause an increase in inflation.
Additionally, there is a great deal of spare capacity in economies and the world banking system is still in difficulty. This combination of factors suggests that inflation is likely to remain low for some time - which is positive for all asset classes, but particularly bonds. In addition, many central banks are not willing to raise rates yet because the economic recovery is fragile and a rise in interest rates could jeopardise this recovery.
The UK is unique in that an election is to take place next month. After the election, whichever party wins, the new government will likely have to introduce bond-friendly measures such as cutting spending to reduce the budget deficit. This could have a negative effect on growth, but would be an excellent scenario for bonds because the Bank of England would have to adjust its macroeconomic projections to take account of this new fiscal landscape, putting further downward pressure on inflation and interest rates.
Strategic bond funds help navigate today's markets
Most bond funds are restricted to investing in a particular sector of the market - for instance, gilts or investment grade corporate bonds. Strategic bond funds, however, have a more flexible mandate to invest in a broader range of fixed interest assets. In an environment of rising gilt yields and where corporate bonds are no longer as cheap as they were in early 2009, such flexibility is crucial to seeking out the areas of the market that offer the best value.
The M&G Optimal Income Fund is one such flexible bond fund that is designed to perform well in a wide variety of market conditions. It is a specialist fund which has a mandate allowing it to invest across every kind of fixed interest asset - gilts, investment grade and high yield bonds - according to the views of the manager, Richard Woolnough. The fund can even invest a portion in equities, where the shares of a company appear more attractive than its debt.
By investing in this flexible manner, Richard looks to outperform the gilt, corporate and high yield bond sectors over the course of the economic cycle - in fact, it is the number one fund in its (IMA) £ Strategic Bond sector since it was launched just over a three years ago (see graph).
Richard explains the flexibility of the fund: "There are two main ‘levers' that drive returns in bond funds - duration and credit exposure. The M&G Optimal Income Fund allows me to pull these levers to varying degrees depending on my economic and market outlook. I am not restricted to following a benchmark or investing in only one area of the bond market."
To hear Richard Woolnough's views first hand, watch his videos at www.mandg.co.uk/iview
For Financial Advisers only. Not for onward distribution. No other persons should rely on any information contained within this article. Source of performance: Morningstar, Inc., as at 31.03.10, bid to bid with net income reinvested, based on Sterling Class A Shares. The M&G Optimal Income Fund was launched on 08.12.06. This Financial Promotion is issued by M&G Securities Limited which is authorised and regulated by the Financial Services Authority and provides investment products. The registered office is Laurence Pountney Hill, London, EC4R 0HH. Registered in England No. 90776.
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