Mark Dampier: Holding on the line for a 'decent' bond yield could mean a long wait

 

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It has been a while since I wrote about a bond fund. The yields of government and corporate debt are exceptionally low by historical standards and over the past four years, many investors have written the asset class off.

US treasuries currently yield close to 2 per cent – what a change from the early 1980s when they were yielding in excess of 14 per cent and the Bank of England base rate was 17 per cent.

Commentators have become increasingly negative in their outlook for bond markets, claiming the "bubble must burst". Against their expectations, government and corporate bond markets have continued to produce positive returns this year.

Chris Higham, the manager of the Aviva Strategic Bond Fund, feels investors may be trapped by history. In the past we have seen much higher interest rates, but they have been declining in the UK since as far back as 1990. The current rate of 0.5 per cent has been in place for more than five years and the last interest rate rise was in July 2007. Yet many people are expecting a return to a base rate of at least 4 or 5 per cent.

Mr Higham does not believe we will see a rise to these levels for some time. He expects the first interest rate rise will be considerably more modest and will take place after 2015. He expects inflation will remain low for several years and he points out that present policy is "cheap but tight", meaning while debt is inexpensive, the availability of it is poor. Just look how difficult it is for first time buyers to obtain a mortgage. This is in stark contrast to before the financial crisis where policy was "loose but dear".

Total government debt is even higher than it was five years ago and it will take some time for this to reduce meaningfully. The situation is not helped by an ageing population in the Western world putting greater pressure on government finances.

Bond markets are in uncharted territory with interest rates at 300-year lows. Mr Higham expects greater volatility in the run up to the general election in 2015. He anticipates a political step change, with the two-party system being challenged. He believes the UK needs new investment to generate growth and expects innovations in technology to result in a period of creative destruction where company outlooks could change dramatically.

Corporate defaults have been almost non-existent recently as company balance sheets are generally in good shape. Mr Higham does not take any strong sector views and believes bond selection is key in avoiding the few defaults that have occurred.

He cites Phones4U as an example. Bonds in the telecoms sector tend to be viewed as an area offering significant growth potential and Phones4U offered an attractive coupon of 10 per cent. Mr Higham avoided the bond, however, as he felt the sustainability of the business model was questionable and the company was over-reliant on a single contract.

The fund currently holds about 20 per cent in financial bonds. The manager feels bankers are encouraged to take less risk in the current environment, knowing they could face jail. The overall policy for banks has been risk reduction, which makes their bonds a more attractive proposition. However, Mr Higham has also been reducing this position; post-financial crisis he feels senior bond holders are less likely to be bailed out by the government in the event of default.

The Aviva Strategic Bond Fund is less well known than the likes of fixed interest stalwarts such as the M&G Strategic Corporate Bond Fund, given it is much smaller at £270m in size. But this also makes the fund considerably more nimble – a few months ago, for instance, it held about 10 per cent in emerging market debt. It now holds very little in this area after selling out at a profit. Its smaller size also enables Mr Higham to run a relatively concentrated portfolio (for a bond fund) of about 80 holdings.

The fund offers an attractive yield of 4.2 per cent. With the Bank of England base rate at 0.5 per cent, and the prospect of a rise far off on the horizon, I feel investors ought to reconsider avoiding bonds altogether.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds in this column, visit www.hl.co.uk

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