Andrew argyle, manager of schroder gilt & fixed interest, attributes good stock selection to the fund's outperformance over three years
In troubled times for UK equities, the UK gilt sector has been a haven for investors looking for safe and steady returns. On average, it has returned 14.99% over three years to 31 July, compared to the UK All Companies sector, which returned -21.56%.
Indeed, over one year, the sector has also outperformed the corporate bond sector, returning 4.69% compared to the corporate bond sector average return of 2.91%, on an offer-to-bid basis.
As a result, equities are historically cheap relative to gilts as investors have been moving away from riskier assets.
Andrew Argyle, manager of the Schroder Gilt & Fixed Interest fund, said gilts slight outperformance of corporate bonds over the past year is unlikely to change in the future, with corporates continuing to marginally underperform.
Argyle said over the past two years a significant amount of pension money has been moving over from equities to bonds and he believes this will continue for another 12-24 months.
Over the past three years, Argyle's fund has returned 17.36%, compared to the sector average 14.99%. He has also outperformed over one year, returning 4.99% compared to the average 4.69%.
Argyle has achieved these figures with an annualised alpha of 1.45, compared to the sector alpha mean of 0.58, but not at the expense of higher volatility, achieving a beta of 0.96, which is slightly below the sector average beta of one.
Argyle said: 'The primary difference between how Schroders manages bond portfolios and how other fund managers manage portfolios is that we place a lot more reliance on duration and position ourselves accordingly.
'We also place a large emphasis on stock selection. I try to add value by capturing points at which stocks are cheap or expensive relative to their fair value, so I am extracting small amounts of value for a little amount of risk.
'If numerous stock selection opportunities are exploited during the course of the year, these amounts of small added value can add up to a significant contribution to total fund performance.'
By doing this, Argyle has to trade the fund actively and, as such, the level of turnover is genuinely higher than most other portfolios.
Argyle does have some exposure to corporate bonds, although the maximum he is allowed is 10%.
By looking at all these avenues, Argyle is trying to exploit every way of adding value.
While he feels gilts are currently slightly expensive on a historical basis, he does not believe they are particularly overpriced.
The long-term nominal yield from investments in gilts should be around 5% per year, according to Schroders. So far this year, gilts are yielding around 4.75%.
Daniel Loughney, manager of the Threadneedle Sterling Bond Fund, said yields have been falling on gilts primarily because of a combination of more stable inflation and strong regulator-induced demand for fixed-income products.
He said: 'We are positive on gilts going forward. There are reasons to believe yields will edge lower, which will give some capital appreciation as well as getting your coupon.'
Loughney took over the Threadneedle fund in June this year, replacing Philip Chow who left to join West Am as head of UK and global spread products.
Over one and three years, the fund has slightly underperformed the sector, returning 3.51% and 13.62% respectively.
As a result, its alpha of 0.51 is slightly below that of the 0.58 sector mean. However, this marginal underperformance is reflected in the fund's beta of 0.91, which is below the sector mean of one.
Loughney said the fund's target index is the FTSE Gilt All Stocks Index but that the FTSE 5-15 Year Maturity Index is the true barometer of where the fund universe is.
He added: 'I want to be long in duration because inflation and growth will fall further and the volatility of these two measures will remain low. This is positive for gilt yields, particularly in the short and medium-dated sector.
On a more cautionary note, Loughney feels a likely deterioration in the Government's fiscal position could act as a drag on longer-dated maturity gilts. As a result, he is underweight bonds with maturities of more than 15 years.
Because of the concerns of the worsening fiscal environment, Loughney feels the yield curve will steepen.
Another negative for the longer-dated end of the market, Loughney said, is the negative sentiment regarding UK entry into Europe. He believes if sentiment towards joining the euro improves, longer-dated gilts would perform better.
Argyle said the forecast for issuance of new gilts is quite small for the rest of the year, adding there is not much supply and that the next long supply of gilts will come later this year.
He added that the Government is trying to spend more and has been allocating the money but faces the problem of where to spend that money.
As a consequence of not fulfilling its spending targets, a ballooning of fiscal deficit is not being witnessed, translating into significant gilt issuance.
With regard to interest rates, Argyle believes the market is not pricing in any rise until the end of the year but is looking for a 0.25% rise in the first half of 2003, with rates likely to reach 4.75% at the end of next year.
He said: 'Economic growth has not picked up anywhere near what the forecasts had originally expected.
'At the moment, with the manufacturing sector being sluggish and the level of growth in the consumer sector likely to be maintained, there is no real necessity to raise rates.'
Argyle feels interest rate rises or falls only hurt gilts when they are not expected by the market. If they do rise as the market expects, he said, gilts will be fine.
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