overweight positions in banks, utilities and property help aegon UK Extra Income reach top quartile with returns of 21.9% over three years
UK Corporate Bond funds returned 7.39% on average over the 12 months to the end of November providing a rewarding investment return compared to equities.
Only one of the 76 funds in the sector, S&W Fixed Interest, posted negative growth over the last year and three funds delivered double digit growth over the same period.
Aegon UK Extra Income, managed by Stephen Snowdon, posted growth of 21.9% over the three years to the end of November 2001 and top quartile performance in each of the past three years discrete performance periods.
The Aegon fund, which yields 6.7%, is actively managed with a total return objective. In keeping with the Autif sector rules, it has a minimum 80% invested in corporate bonds, although Snowdon has scope to invest up to 10% of the fund apiece in both high yield and gilts.
Given the weak correlation between high yield and corporates, especially when compared to the close correlation between corporates and gilts, this willingness to diversify the portfolio has assisted Snowdon in delivering consistent outperformance without any significant volatility of earnings.
Stock selection comprises both bottom up credit analysis as well as top down macro views which are used to sculpt the fund's duration profile.
Over the 12 months to the end of November, Aegon UK Extra Income is up 7.82%, compared to a sector average of 7.39%. Snowdon said the fund has been heavily underweight AAA-rated paper for the two years, with holdings averaging an A-rating and the 10% high yield allowance fully invested.
While undoubtedly boosting the numbers, the high yield exposure does increase the fund's risk profile, characterised by its 1.23% beta, significantly higher than the 0.99% sector mean. The pronounced deviation from the fund's benchmarks is also embodied in the fund's well above average R-squared of 0.68 compared to the sector average figure of 0.85%.
Snowdon said the portfolio typically comprises between 35 and 40 holdings and fund turnover is quite high, averaging 300%pa, a consequence of the fund's market direction calls, which can naturally result in regular adjustments to the portfolio.
In terms of sector exposure, Snowdon is overweight banks, utilities, property and securitised paper, all of which have outperformed over the past 12 months.
Snowdon said: 'In the first half of last year we were considerably shorter than our benchmarks and when the rates came down we outperformed. We took that position off in the summer and got the sectors right too.'
Snowdon's largest holding is currently high yield, which has also boosted the fund's numbers in the short-term.
Snowdon said: 'Our largest position is Yell Finance, which was split out of British Telecom via a leveraged buy out last year. When issued, they were yielding 10.75% and they have since done very well and are now yielding just over 9.5%.'
The fund's weighting in high yielding utility stocks was also upped last November, as Snowdon and his team sought out unfairly derated stocks marked down in light of the Enron debacle. The sector has since bounced back and high yield has outperformed over the last two months.
From December 1999 to November 2000, the fund was up 7.49% versus a sector average of 6.88% and from December 1998 to November 1999, the fund posted growth of 5.17% compared to a 2.42% sector average.
Snowdon explained: 'We had a good 2000 as well. Again, a lot of that was down to sector and stock selection. We were probably neutral on duration. In 1999, we had a very good year in terms of calling the market direction and stock selection.'
The outperformance of the last three years has led to an annualised mean return of 7.03%, compared to a 5.74% sector average, which equates to top decile performance.
The Gartmore Corporate Bond Fund also outperformed last year on the back of overweighting financials and utilities, along with telecoms. The fund returned 8.53% over the 12 months to the end of November, outperforming the sector by 1.15% and over the three years to the end of November, posted growth of 20.11%, outperforming the sector by 2.21%.
Fund manager Eran Peleg has managed the Gartmore Corporate Bond fund for three years now and upon assuming the role of lead manager, orchestrated a re-engineering of the fixed interest investment process.
The enhanced risk control process limits sector and stock bets and gilt exposure is used as a defensive mechanism to mitigate widening credit spreads as and when they occur.
Peleg said: 'In terms of investment style, we try not to take a huge amount of risk. We may have small sector or duration bets but try to avoid the risk being taken all in one area.
'We also focus on the relative attractiveness of corporates versus gilts and we can at times take a view on that if we think credit spreads are going to widen.'
Stock selection has been particularly crucial over the past year, as a number of bonds have underperformed or defaulted, Peleg said.
The fund's move into telecom companies, such as British Telecom, Worldcom and Telecom New Zealand, has been one such small, yet successful sector bet.
Peleg said: 'We still quite like telecoms and they still look cheap relative to their respective credit ratings.'
The average credit rating of the fund's holdings is A minus, and it currently holds 80 stocks.
The fund is flexible in terms of credit rating exposure, as exemplified by the portfolio's outperformance in 2000 on the back of heavy AAA exposure. In the discrete period between December 1999 to the end of November 2000 the fund returned 8.4%, compared to a sector average of 7%.
Peleg said: 'In 2000 we had large emphasis on AAAs because we wanted to be defensive. Moving into 2001 when central banks started to cut rates aggressively, we moved away from AAAs, but were still reasonably defensive in terms of cyclical exposure.'
The fund marginally underperformed in the discrete period from December 1998 through November 1999, posting growth of 2.09% compared to a sector average of 2.42%. This coincided with Peleg's overhaul of the fund and the fixed interest investment processes.
Over the last couple of months, Peleg has been increasingly looking at the more cyclical areas of the market as he feels the market is very close to a bottom, while interest rates look likely to remain stable for the near-term at least.
Peleg said: 'We think interest rates will remain on hold now for quite a while. It has not got much scope to fall further and inflation risk is very low anyway.
'As most central banks focus on inflation, rates will stay on hold for a while.'
That said, Peleg believes corporate bonds still have scope to do well if the economy starts recovering and he is focussing particularly on those areas that underperformed last year.
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