Interest rates in most major Western economies are not going to rise anytime soon. Ben Bernanke, the chairman of the US Federal Reserve, has made it clear that interest rates won't move until 2013 at the earliest. Mervyn King and his colleagues at the Bank of England are likely to follow suit. In Europe, interest rates were, unbelievably, pushed up despite a huge debt crisis, but they are clearly going to fall again.
In this environment one would have expected bonds to rise in value. The yields on German, US and UK government bonds have indeed fallen to historic lows as prices have risen and investors have sought a safe haven during the recent stock-market volatility. Yet, this in itself is somewhat strange given the level of debt these nations have. In contrast, the vast majority of other bonds have fallen in value. Corporate bonds in particular have had a difficult time; especially high-yield bonds which tend to move more in tandem with equity markets. Similarly, anything with any financial involvement has fallen further as worries over the eurozone debt crisis continue.
Strategic bond funds, including the Artemis Strategic Bond Fund, managed by James Foster, have also struggled. It could be argued most have not been strategic enough. They have nearly all been bearish of government bonds in the UK. Some have even shorted the market, positioning themselves to benefit from falling prices when they should have been long as gilt yields have continued to fall and prices rise.
Mr Foster has about 6 per cent of his fund in gilts, but still "hates them". He believes the low yields say more about fear than anything else and while fear prevails it seems possible for gilt yields to fall below 2 per cent. He prefers bank debt because it gives "more bang for your buck". Banks have more capital now than they did two years ago, yet default rates for the financial sector are suggesting most banks will go bust. We could see one or two failures, but he believes we are at extreme levels of distress. Once panic subsides and confidence returns he believes the fantastic yields on offer will fall, meaning prices will rise.
Elsewhere, Mr Foster sees plenty of value in corporate bonds. Implied default rates on investment-grade bonds have risen to 15 per cent over the next five years while the equivalent figure for high-yield bonds is around 45 per cent. Defaults on this scale would be unprecedented and Mr Foster believes these numbers are excessive. Presently, around 45 per cent of the fund is invested in high-yield bonds, with just over 50 per cent in investment grade.
Mr Foster suggests more quantitative easing (QE) will be announced across Europe, perhaps under a different guise as Germany, for historical reasons, doesn't like the idea of money printing. We will probably see more QE in the US next year and almost definitely in the UK, too. Only this week George Osborne, Chancellor of the Exchequer, nudged the Bank of England towards a new round of QE and announced "credit easing" – a new mechanism to stimulate bank lending whereby the Treasury would buy billions of pounds worth of bonds, or debt, in businesses to help ease their cash flow and encourage banks to lend more cheaply.
With a yield of around 5.6 per cent the Artemis Strategic Bond Fund, like many such funds, offers an attractive return compared to cash deposit. Although unlike cash, the value of your capital will fluctuate. With no resolution to the eurozone crisis we are trying to catch a falling knife and financial bonds will remain under pressure. You have to wait for that ERM moment – when the outlook suddenly becomes clearer – to buy into funds such as Artemis Strategic Bond.
Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independentReuse content