The Analyst: The name's bonds, corporate bonds

I have decided this week to revisit a fund I highlighted as recently as March this year – M&G Optimal Income. The reason is simple: I feel that its story gets stronger and stronger as each week goes by.

M&G Optimal Income is a bond fund, but one that gives the fund manager, Richard Woolnough, access to a wide range of trading strategies. This is important because there are many types of fixed-interest investments, and they will perform differently in different economic environments. The flexibility to move freely between them means that Mr Woolnough is better able to position the portfolio in the most favourable areas.

This is a strange time in the bond markets. Investment grade bonds have fallen by far more than high-yield bonds (sometimes called "junk" bonds). This shouldn't happen. Logic dictates that the high-yield bonds will suffer most during an economic downturn, as the companies issuing them are more likely to go bust.

The current market is topsy-turvy because there has been a flood of investment-grade bonds being sold on to the market by hedge funds and institutions looking to unwind their extremely leveraged portfolios. As a result, prices have been forced dramatically down and yields driven up.

Richard Woolnough remains wary of many of the financial bonds that other fund managers are buying. This is because a bank's debt structure has different levels of liability and risks. For example, what is called "Tier 1" might be far more risky than many investors anticipated.

Interestingly, Northern Rock has a Tier 1 bond that is due for redemption this month. If Northern Rock is unable to repay the bondholders (a distinct possibility), then this will have a negative effect on the value of Tier 1 bonds across the market. Mr Woolnough is one of the few fund managers who has refused to have exposure to bank debt.

The chart accompanying this article is a bit different this week. Rather than the performance of the fund, it shows the UK housing market versus the number of mortgage approvals that are granted. There is a direct correlation between the number of mortgages being improved, and the value of houses. This is all pretty logical. The unfortunate message for estate agent and building society associations who continue to forecast an imminent upturn in the market is that mortgage approvals are still going down. This must surely translate into even lower house prices; Mr Woolnough predicts that by April next year they will be down by 20-25 per cent from their peak last October.

Continuing weakness in the housing market here and in the US (despite the recent events surrounding Freddie Mac and Fannie Mae) is bad news for our Gross Domestic Product. Falling GDP will spell even more trouble for our beleaguered banks and construction companies.

Mr Woolnough expects, as do I, that interest rates will have to fall sharply next year, and this should be good for bonds. So he argues that the present economic environment is bond-friendly, but credit risk remains a concern. The M&G Optimal Income Fund therefore remains exposed to relatively short-dated bonds, thus lessening the risk to the fund of companies getting into financial trouble.

While there is still much talk of inflation, if you look at the direction of both the housing market and commodity prices, I believe that we will soon be talking about deflation. So those of you enjoying 6.5 per cent gross yields in deposit accounts at the moment shouldn't expect that to continue. I believe that interest rates could easily fall below 4 per cent next year, which would provide an excellent foundation for upward momentum in bond prices. One word of warning: if you wait for the fall to happen, it could already be too late to capture much of the growth in funds like this.

(For anyone who's keeping score, since I last featured this fund in March it has risen by 3.4 per cent, ranking it sixth out of 55 funds in its sector.)

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