The Analyst: Cloudy economy has a silver lining

Frequently in this column I have suggested that market falls, while worrying and uncomfortable, present investors with buying opportunities. The current economic climate does not look overly favourable for equities. However, one area in which I can see a great opportunity is corporate bonds. While I feel the economic outlook is especially poor, I do believe that investors in some areas of the bond market, the high-quality investment grade bonds, for example, are being extremely well compensated for the risk.

The current economic climate is so uncertain that it demands flexibility. This has been recognised by Jupiter who launched their Strategic Bond Fund in June this year. The fund is managed by Ariel Bezalel who has more than 10 years experience in the fixed-interest markets. Mr Bezalel has a flexible mandate where he can invest in government, corporate and high-yield bonds. You might think these were all the same, but they perform very differently in different economic cycles.

Government bonds perform well in a recession and falling inflation. These are the least risky as they are guaranteed by the government. Investment grade corporate bonds do well in an environment where there is some growth but where there is also low inflation and falling interest rates. High-yield bonds need fairly buoyant economic conditions, rather like equities. The latter two are backed by companies, but these are differentiated by their credit ratings. These ratings basically indicate the potential risk of the company defaulting on its loan. The riskier the company, the higher the yield – in other words investors are compensated with a higher yield for the extra risk they take with their capital.

The global credit crunch has caused a huge dislocation within the corporate-bond market and opened up opportunities in areas like the financials sector. Clearly this might sound bizarre as the banks are having a torrid time. In fact, the yields on the bonds issued by the banks have risen to such elevated levels that the current default rates are implying one in five banks will actually default. This is something which the majority of bond-fund managers, including Jupiter, feel is unlikely. The banks are trying to restore their balance sheets and focus on paying down debt, which is good news for their bonds.

The Jupiter Strategic Bond Fund currently has a large exposure to the banks, but its main focus is on the senior debt that has to date never defaulted. We expect the banking industry to suffer more regulation, given their problems, and this will make them into boring businesses. But this is exactly what bond managers like. They want reliable companies with robust business models, solid management and very predictable earnings.

Mr Bezalel's investment process starts with an overview of the wider economy, looking at where we are in the business cycle. This takes into account factors like inflation and the interest rate outlook. Assessing the prevailing environment allows the manager to focus on picking bonds with the best potential return based on their credit quality and yield against the economic backdrop.

The fund currently yields 7 per cent, which within an ISA or a Sipp (self-invested personal pension) is, in effect, tax free. It has grown to £70m in size, making it nimble. While fixed-interest markets are huge, liquidity can be a problem and a smaller fund should therefore have a real chance of outperforming.

Around half the fund is invested in the high-quality investment grade corporate bonds. These are mainly in the financials sector, where there are prospects for growth. The other half is in high-yield bonds, which are mainly in short-dated bonds that basically have a short life to maturity, but these are in strong businesses. There is also good geographical diversification with exposure to the UK, US, Europe and other overseas markets.

As we are experiencing high inflation, it is hard to see interest rates fall, but this is what I expect will happen at some point in the near future. This will be a good environment for many bonds. In fact, I believe that deflation is likely to be a problem in the next year simply because the paying back of debt is deflationary, not inflationary. With the housing market also under severe pressure, this should lead to a fall in interest rates.

I believe bond yields are currently so attractive they will not be around for long, and investors need to snap up opportunities through funds like this, which are looking to take advantage of the high yields and deliver capital growth over the longer term.

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