Mark Dampier: Corporate bonds show signs of life

The Analyst

It was almost a year ago that the Old Mutual Corporate Bond Fund featured in this column. Corporate bonds are loans to companies, which pay regular interest and pledge to repay the loan at a certain date. As investments, these have suffered (along with everything else) in the credit crunch, and also due to fears of inflation in the years ahead.

Unfortunately, in 12 months it has fallen 19.6 per cent against an average fall for its sector of 5.5 per cent. And this is despite a very strong rise since March. That is hardly the sort of performance I would have expected from a corporate bond fund, which should have relatively low volatility. So what went wrong?

The answer is two-fold. First, it is fair to say that Steve Snowdon, the fund manager, suffered from being invested in the banking sector, and indeed in some of the most economically-sensitive companies in the UK at the time of a downturn. In addition, like many corporate bond managers, he suffered from the severity of the credit crunch when the US government allowed Lehman Brothers to go bust. It could be argued this one event exacerbated the credit crunch from a big problem to a major crisis.

For whatever reason, probably political, it seems US Treasury Secretary Henry Paulson wanted to be seen to punish one bank, and it was Lehman Brothers that came into the firing line. What he hadn’t realised was the knock-on problems throughout the whole economic system. Holders of bank bonds became very nervous; the government had shown it would let a major banking institution fail. The result should have been easily predictable; they started to sell their bonds as fast as possible and prices crashed.

Things became worse in the UK when it seemed briefly as though most of our banks could be nationalised, causing further anxieties for bond holders. Prices of some of the bank bonds fell from their issue price of 100p to around 10p. However, things started to change in late February and early March as the Government injected huge amounts of cash and also promised depositors they would not lose their money.

A wave of optimism spread through the corporate bond market and prices have crept up since. From its low point in March, the Old Mutual Corporate Bond Fund has surfed this wave of optimism and made big gains, although it is still some way from recouping its total losses. Mr Snowdon has been paring back some of the smaller positions in the fund, particularly in holdings such as Irish Banks, using the opportunity of better liquidity to sell bonds he felt were too risky.

After meeting with him recently, I felt he was more confident about the fund and has learnt a lot from last year. He has, for example, broadened out the portfolio to more than 100 holdings in an attempt to add greater diversification and lessen the risk. He believes we are about a third of the way through a bond market recovery and has strong conviction that, although there may be some wobbles along the way, if he can make the right calls the fund will perform significantly better this year.

Compared with many other corporate bond funds, the Old Mutual fund is more sensitive to its companies’ creditworthiness than to movements in interest rates. If Government gilts continue to fall in value, this fund should be less affected than much of its peer group. However, if the economic situation materially worsens again then fears of defaults will rise again and the fund could struggle.

Within the corporate bond sector, this is a higher risk fund, although that means potentially higher growth too. In the meantime, the income is 10.9 per cent, and remember this income is tax-free within an ISA or SIPP. Mr Snowdon is much chastened after his experience of last year, and I think the fund has every chance to come right now.

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

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