The Analyst: Why it's time to get back into bonds

As I write, the UK stock market is approaching the lows it reached back in March. The economic news continues to be poor and, given that the housing market seems set to continue to fall, I can't see the news getting better any time soon. House builders have been slaughtered, despite the fact that they have enjoyed a 10-year bull market.

The trouble is that this will feed all the way through the supply chain. It doesn't only affect the construction workers, but also industries from furniture makers to removal firms. A falling housing market has profound implications for the UK economy.

In a normal downturn, you would expect interest rates to fall to help boost the economy. However, the Bank of England's remit of a 2 per cent inflation target is stopping them doing this for the time being. That said, interest rates have effectively been going up anyway for those who have got a mortgage; those remortgaging are finding that the real cost of borrowing is much higher than the base rate would imply.

Despite this doom and gloom there are opportunities in both equities and bonds. This week, I want to concentrate on bonds, specifically the Old Mutual Corporate Bond Fund managed by Stephen Snowden. Bonds have also been punished because of rising inflationary expectations. The Old Mutual fund invests in investment-grade corporate bonds, which are borrowings from companies rather than governments. Not only have these suffered on the back of inflationary expectations, but also because of the credit crunch.

Financial institutions have been forced to sell bonds in order to raise cash for their balance sheets. As with any market that has forced sellers, bargains start to appear quite quickly, as those desperate to sell have to take whatever price they can get. This has probably thrown up one of the best opportunities to buy bonds for many, many years. Indeed, Stephen Snowden reckons that if you don't buy them now you never will. He believes (rightly, in my opinion) that the fall-off in demand that we are experiencing in the UK, the US and the rest of western Europe will in itself lead to low inflation later.

Remember that filling up your car, buying food, and paying the utility bills is all sucking money out of your pockets. Because of this, I feel that, in a strange way, these rising prices are actually deflationary.

In other words, they mean we have less money to spend in the shops and this should keep prices for all non-food and non-energy purchases low. This would give the Bank of England an opportunity to reduce base rates. Ideally, these should be much closer to 4 per cent in the current environment instead of their level of 5 per cent.

Compared with the last recession in the early Nineties, this time most workers are not in the position to ask for higher wages. Perhaps the only exception is the public sector, which seems to think it is immune from the economic problems and can hold us all to ransom. Indeed, public sector workers are the enemy at the gate and are as troublesome as trade unionists were in the 1970s.

However, if the Government has the courage to hold the line on wage increases (although courage isn't something politicians are known for) then interest rates are more likely to start falling next year.

Mr Snowden is finding opportunities in the financial sector. He believes that banks have still not revealed the true extent of their losses and feels more horrors will come through. The sooner that happens the better, though, and perhaps by the end of the year everything will have come out of the woodwork. Once that happens, the banks will feel more comfortable about lending to each other, which is something we desperately need to help grease the wheels of the economy.

So where does that leave the fund? It currently has a yield of 7.5 per cent, which looks remarkably good considering the prospect of some capital growth on the underlying bonds, too. I have not been a bond fan for many years, but I really do think there is an opportunity in this asset class and with this fund in particular. Remember, too, that when the fund is held in an ISA or Sipp the income is tax free.

Stephen Snowden is the man who said a few years ago that investors would be better off in cash than bonds in the short term. I doubt Old Mutual's marketing department was very happy about that, but his honesty was proved right then. He is far more bullish now and I believe he will be proved right again.



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

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

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