Mark Dampier: They say the only way is down but some bonds are yielding to no one
Saturday 25 May 2013
Forecasters have called the top of the bond market on numerous occasions over the past two years, but gilts have resolutely not behaved in the way in which many bond fund managers expected. Today, 10-year gilts are yielding 1.9 per cent. Yields may have touched a low of 1.4 per cent last summer, but in reality they have settled in a tight trading range.
Those who have shorted gilts in anticipation that prices will eventually fall have thus far suffered the consequences. Betting against central banks is seldom a good policy; as liquidity has continued to be pumped into the markets via quantitative easing (QE), gilt prices have remained stubbornly high.
By historic standards, bonds are expensive. It is not inconceivable that prices will remain elevated for some time yet. We are living in a very different world, for the time being at least, where a continuation of ultra-low interest rates is forcing investors to hunt for yield in all sorts of asset classes. An extension of the Bank of England’s Funding for Lending Scheme means banks don’t require our deposits, driving interest rates lower – with every likelihood they could fall further. Against this backdrop, it is not surprising that gilts have not seen a dramatic yield rise.
Aside from gilts, all areas of fixed interest are in demand. This includes more risky high-yield bonds, which have been touching on levels not seen historically. This does not mean value can no longer be unearthed in this area of the market, but care does need to be taken. It is for this reason that I prefer to invest with an experienced bond fund manager, who can make the decisions for me.
Eric Holt, manager of the Royal London Sterling Extra Yield Bond Fund, acknowledges the dangers but is still finding plenty of opportunity. While Mr Holt views the gilt market as expensive, he does not expect its direction to change any time soon, believing there is potential for further QE in the future. In an environment of low growth, low interest rates and relatively low inflation, this is exactly the type of environment in which bonds could do well.
At present, Mr Holt’s fund has 42 per cent invested in high-yield bonds, with a further 35 per cent in unrated bonds. Unrated bonds are issued by companies that haven’t paid an agency for a credit rating; Mr Holt prefers to do his own research into a company’s strength rather than relying on ratings agencies. Many of those held in the portfolio are collateralised bonds, secured against the assets of the company issuing them. Being unrated, these bonds also tend to offer a better rate of interest.
The Royal London Sterling Extra Yield Bond Fund currently offers a running yield of 6.15 per cent, which is tax free in an individual savings account or self-invested personal pension (Sipp), and dividends are paid quarterly. Investors must bear in mind that this fund should not be considered low risk simply because it has the word “bond” in it – a common misconception. Indeed, the fund was severely hit, at least in terms of its capital value, during the credit crisis in 2008. Mr Holt, however, held his nerve and the fund has since doubled in value.
He has recently purchased seven- year mortgage debentures issued by Alpha Plus Holdings, yielding an attractive 5.75 per cent. The bond is secured on property, in this case London private schools. Mr Holt has also bought bonds issued by Annington Finance, which are secured on Ministry of Defence accommodation. Mr Holt recognises that liquidity for these bonds is low, but at a yield of 10 per cent, he feels he is being appropriately compensated for the risk taken.
The best bond returns are likely to be behind us, but Mr Holt is confident he can deliver attractive total returns from a combination of both income and capital growth. A large part of my own Sipp is invested in this fund, enjoying the benefits of tax-free income. In my opinion, interest rates are unlikely to rise any time soon. As the search for yield continues to gather momentum, I am happy to hold this fund until the facts change.
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.hl.co.uk/independent
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