The Analyst: Could bonds be ready to bounce back?

I return this week to the subject of fixed interest, otherwise known as bonds. This generic term often confuses investors, but it actually encompasses a huge range of investments.

At the lower-risk end we have government gilts, which are guaranteed by the government (although saying that always makes me feel somewhat queasy). From there, we can go all the way up to high-yield bonds or, as they are often called, junk bonds. These are issued by companies that are generally thought of as higher risk, and the extra yield you receive comes at the price of no guarantee that you will get your money back.

Between these two extremes is a plethora of other types of bonds, but you will be happy to know that I won't go into detail about them now. However, it makes a great deal of sense to select a bond fund that can use and maximise a wide range of fixed-interest instruments.

One such is the M&G Optimal Income Fund. The fund is run by Richard Woolnough who, in my opinion, is one of the top bond managers in the industry. He examines the current economic environment to help him make the best selection of bonds.

This is important, because different types of fixed interest will do better in certain economic environments. Government bonds tend to do well when inflation is low and the economic environment is relatively poor. On the other hand, high-yield bonds thrive in a stable and growing economy. They have been hit hard recently as the economic outlook becomes murkier, but many managers – including Mr Woolnough – believe they now attractively priced compared to their risk.

Once asset allocation is decided, Mr Woolnough can focus on sector and stock selection. He will take into account valuations, the covenants on the various bonds (that is, the promises and restrictions on paying money back to bondholders) and liquidity (that is, the ability to trade quickly, which outside government gilts can sometimes be difficult).

I think it is interesting to see Mr Woolnough's overview of the overall environment, particularly the housing market, which will have a major impact on the economy and the fortunes of the influential finance sector. We are all aware now that the US housing market has been falling. In some areas, such as Miami, falls of almost 20 per cent have now been seen. Their housing problems have been caused by poor lending practices and a glut of housing (which are not the same problems we have in the UK), and Mr Woolnough believes that the UK housing market is likely to follow the US downwards.

This is based on indicators such as mortgage approvals, which are an advance warning for falling house prices, and which have fallen off substantially. Mr Woolnough believes this year could see a fall of at least 5 per cent. Perhaps here you should remember that very few property commentators have been suggesting this. They prefer to use words such as "flat". The trouble is that markets hardly ever go flat; they are either moving up or moving down. Given that the UK housing market has risen some 200 per cent over the past decade, would it be surprising to see a move down? Surely the answer is no.

The good news on bonds is that credit spreads (the difference in yield between government and corporate bonds) are now at their widest since 1983. Managers such as Mr Woolnough consider them to represent excellent value at this level.

One example is Kingfisher, which has a bond that pays 6 per cent more than gilts. Clearly it is also more risky, but Mr Woolnough believes the extra yield is well worth the risk. A key area where he differs from other fund managers is in his small exposure to financials. Bonds in financial companies have, as you might expect, taken a tumble along with their share prices. Mr Woolnough has cut exposure in this area and moved into higher-quality bonds.

The fund at present has a yield of 5.56 per cent, although of course this will vary over time. One major advantage in buying a bond fund is that if you hold it in an ISA or Sipp, the income is tax-free.

Private investors have been shunning bonds for a couple of years, which isn't surprising given their rather poor performance. But two years ago you weren't being paid to take the risk. Now you are. The present credit crisis won't go on for ever (although it may feel like it), and this is the kind of fund that I believe will benefit over the coming years.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent