Gartmore fund manager Eran Peleg sees investors looking for yield increasingly turning to the corporate bond sector
Eran Peleg, manager of the Gartmore Corporate Bond fund, believes investors looking for yields similar to those available in the early 1990s will find them in the corporate bond sector.
Peleg manages Gartmore's two existing corporate bond funds: the £200m, five-star, A-rated, Corporate Bond and £150m, High Yield Corporate Bond portfolios.
Peleg joined Gartmore's fixed income team in 1997 and took over running the Corporate Bond fund in June 1999. He is also to manage the Gartmore Monthly Income fund, which is being launched on 8 February, as revealed in Investment Week in November last year.
Over 12 months to 9 January 2002, the Corporate Bond fund is ranked 37 out of 75 in the UK corporate bond sector, returning 0.4% on an offer to bid basis, compared to the sector average 0.7%. Over three years to the same date, the fund is ranked 19 out of 57 funds, returning 7.2%, compared to the sector average 6.1%.
Do you take a top down or bottom up approach to managing the portfolio?
Generally both. Bottom-up is very important. In corporate bonds the risks are asymmetrical. If a company does well, you don't enjoy the upside as with equities, but if things go wrong, you have all the downside. In that sense, it is important to carry out rigorous bottom-up analysis ' looking at each company in order to avoid blow-up situations.
You cannot lose sight of the top-down picture and the macroeconomic situation, however, because in a downturn, you have to be cautious on the cyclicals. For that, we work closely with the Gartmore macroeconomic research team and our own fixed income strategy team.
Top-down and bottom-up are both important but over the past year, we have been more focused on bottom-up risks, which has worked as we have managed to avoid most of the weak situations.
How do you research the different bonds?
I have a team of three credit analysts. I also work closely with the equity analysts because we look at a lot of the same companies, only from a bond, rather than an equity, perspective.
A large part of the analysis is similar in that we tend to focus on the same things ' the strength of the franchise and the management, which I call business risk. When it comes to the financial risks of companies, we diverge from equities because we focus more on cashflow and leverage, whereas equities concentrate more on company earnings and upgrades.
Looking at the liquidity situation of companies and asking whether they have access to capital markets is also important. You have to know whether the company has committed bank lines, whether it can tap equity markets and, if it does find itself in a distressed situation, what assets can be commoditised to improve its liquidity ' for example, does it have non-core assets it can sell?
If a company can do these things, it will have the ability to recover from a distressed position. An example of this is BT, which was able to cut its debt by 50%. BT bonds have performed well on the back of this recovery.
Has investing in corporate bonds become more stock specific?
One of the things the past two years have highlighted is the need to avoid blow-up situations, of which we have seen quite a few, like Enron and Marconi. The environment we have been in has highlighted the importance of focusing on bond-specific risk. However, this does not mean sector selection is not important.
If you held financial bonds in 2001, it did not matter as much which you held because the whole sector performed reasonably well and the returns were highly correlated. However, when you get into the cyclical sectors, it is much more about stock-specific risk. It depends on the sector but, generally, sector selection is still very important.
How much attention does your research process pay to the rating agencies?
We actually rate every bond that we buy. We look at S&P and Moody's but we do not base our investment decisions on them, they are simply another input into our process.
It is obviously important for us to understand what the rating agencies are thinking because if a different bond gets downgraded tomorrow, it will have an impact on the marketplace. However, for us, in deciding whether we want to take on the risk of buying a bond, we do our own analysis and come up with our own rating.
How many bonds do you hold in the portfolio and what paper do you invest in?
The Gartmore Corporate Bond fund invests predominantly in investment grade bonds. I currently have about 75-80 holdings but we do have some flexibility at the margin to expand either way.
If we think we should be extremely defensive and that corporate bonds will underperform gilts, we can have a holding in gilts. In the first half of 2000, we had a view that gilts would outperform so we had a 10% holding in them.
We can also expand into high yield. We have 7% there at the moment because we think these will do well going forward. However, the fund will always be predominantly investment grade and will never have more than 20% in either high yield or gilts.
Do you think the popularity of corporate bonds will continue to rise?
Yes, definitely. We might see more government bond issuance going forward because we are seeing more spending by the UK Government through increased spending plans. There may be more of a need to issue gilts to finance this.
We will see continued demand for corporate bonds both from retail and institutional investor. In corporate bonds, the risk/reward profile looks attractive relative to gilts. Default rates on investment grade bonds are still very low.
FRS 17 is pushing pension funds into bonds and we will see continued demand from retail investors looking for income. Yields have fallen from 15% to 5% since the start of the nineties and people are looking for opportunities to get a bit more. They will find it in the corporate bond market.
Looking into 2002, what will happen to the yield curve?
I really do not have a strong view on the yield curve at the moment, which means I do not have a big position based on it in the fund. Any positions I have are linked to a view. If we have strong view, we take risk; where we do not have strong views, we won't take risk. I take risk where I am paid to take risk.
What duration risk do you take on the fund?
We do not take huge amounts of duration risk. Generally, our philosophy is that you do not take a big bet in any one area. We never take very large duration, yield curve or sector positions because of the risk of it going wrong.
We look for diversified sources of alpha so we take some duration, some sector and some yield curve risk to produce consistent returns over time.
What sectors are currently looking interesting?
In the sterling bond market, we have been looking closely at the more cyclical areas. Over the past year, the market has moved to the stage where it has priced in all the bad news. The question is whether we have reached the stage where we should be a bit more comfortable buying some of these bonds.
We are now around the bottom of the cycle. Some cyclicals are pricing in the bad news so we are selectively going into this area. However, there is still some company-specific risk involved.
AAA bonds do not currently look as good as they did. For a large part of 2000, they were the best performing sector; now, there is not much value to be had.
They are about 30 basis points over gilts so they will not do well going forward. We have been underweight in this area for much of the year.
Peleg joined Gartmore in 1997, with responsibility for managing the group's credit portfolios. He is also involved in the formulation of credit market investment strategy.
He was previously employed as a teaching assistant in finance at the Hebrew University Business School in Israel.
Peleg has an MBA from the Said Business School of Oxford University. He graduated from the Hebrew University in Israel in 1995 with a BA Cum Laude in economics and philosophy.
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