Last week Stephen Snowden visited our office to discuss the Kames Investment Grade Bond Fund, which he has been running for six months since joining from Old Mutual. Over this time it has not been easy being a bond manager. Those that haven't had most of their assets in gilts have found it tough. However, the fund isn't allowed to invest entirely in gilts as it is predominantly a "credit" fund. This means it has to buy corporate rather than government bonds.
The eurozone crisis has brought sovereign bonds into sharp focus in terms of whether they are really safe. Already we have seen Greece, Portugal and Ireland unable to raise money from the open market at anything other than punitive levels, and there is now a danger Spain and Italy may join them. Yields in the latter two countries have been over 6 per cent, and in the case of Italy they hit 7 per cent, making borrowing prohibitively expensive. If they can't go to the market to raise funds they must go elsewhere and this may include the IMF. The danger is Europe runs out of firepower. The Germans are resolutely against any form of quantitative easing, but the longer this goes on the more likely they will have to give in and effectively print money to continue buying up distressed sovereign bonds.
Unfortunately it looks like the Germans may take this to the brink. If they give in too early, it will seem like profligate countries have been let off the hook, making them less likely to take austerity budgets seriously. This opens up the possibility of the markets taking control and forcing the politicians' hands, which means equity and corporate bond markets may well fall further as investors shun risk assets.
For this reason Mr Snowden has been somewhat defensive, and he has no exposure to the southern Mediterranean banks. He has been watching business confidence indicators turn down as companies delay making investment until they are sure of what is going to happen. It is this paralysis that is likely to cause a recession in Europe and, in turn, the UK. Despite valuations in credit markets looking relatively appealing he believes spreads (the difference in yield between what you can obtain on a government bond and an equivalent corporate bond) could increase further. In other words until he sees further falls in corporate bond markets he refuses to become more bullish.
Yet he has to be careful about being too defensive. He warns that liquidity in the corporate bond market is poor again, in other words it is difficult to buy or sell large positions. So while things might get worse before they get better, when the market turns he believes it will happen quickly and there will be little chance for any bond managers who are sitting in gilts and cash to get on board. This is precisely what happened in 2008 as more aggressive funds sharply rebounded, quickly overtaking those more defensively positioned. He is therefore sticking to his mix of bonds of global companies such as BP, Johnson & Johnson and Petrobras.
So while Mr Snowden is rather negative in the short term, he is sure at some point next year there will be a quick and significant turn-around. He is not alone in feeling that while valuations are cheap they may get cheaper.
Although the fund has a decent yield of over 4 per cent it may be best for investors to phase their way in, rather than buying a big holding in one go. With short-term deposit rates likely to stay very low for the foreseeable future, corporate bonds do look attractive, but I believe it is worth building exposure slowly.
Mark Dampier is head of research at Hargreaves Lansdown, asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent