In over 30 years of watching markets, I’ve very rarely heard most of the top investment managers in a sector agreeing that it is a great time to buy. If they’re right, you could make 15-20% over the next year with very little risk.
The managers in question are in the fixed interest sector, not in shares. Share markets are still in the grip of the uncertainties about the economic consequences of the credit crunch. But in fixed interest markets events have moved faster, to the extent that some classes of fixed interest look remarkably good value.
Top managers such as Paul Read at Invesco Perpetual, Stephen Snowden at Old Mutual and John Patullo at Henderson have all issued ‘buy’ calls on the UK corporate bond market in the past two weeks. I’ve selected three funds I believe most likely to deliver good returns over the next 12-18 months.
A few managers are still on the sidelines, such as David Roberts at Aegon and Richard Woolnough at M&G. But even they agree that prices are absurdly cheap. The reason the managers think it’s time to buy is that fixed interest markets have moved faster in response to the credit crunch than share markets.
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Investors panicked and sold
The first reaction of investors in the credit crunch was to sell anything that looked risky and buy things that looked safe. The safety play has been bonds issued by trustworthy governments and financial institutions, so the prices of US Treasury Bonds and UK gilt-edged securities have risen as investors have piled in.
At the same time, investors sold indiscriminately not just the mortgage bonds associated with the US sub-prime problems but pretty much everything else apart from government bonds. The result is that today, gilt yields are about 4.5% while A rated corporate bonds yield 7.5%
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Banks pay to raise cash
One reason why yields in the corporate bond sector have soared is that banks have had to raise fresh capital and have had to do so on terms dictated by investors. So giant banks like HBOS, RBS, UBS, and Barclays have offered interest rates of as much as 8-9% in recent financings – all of which have been quickly snapped up.
The managers who are keen on corporate bonds are only keen on quality. They think a weakening economy could spell trouble ahead for ‘high yield’ or junk bonds where the company itself doesn’t have a strong financial position or has simply borrowed too much.
So the sector the managers think is cheap is ‘investment grade corporate bonds’, where the company is considered sound and investors are more confident they will get their money back even if the company gets into trouble.
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Yield premium goes off the charts
Last year, if you bought bonds like these you got only a fraction of one percent more than from a bond issued by the government. Today, you get 3% or even 4% more, even from big banks and blue chip companies. Managers say it’s right that you should get a reward for the small degree of extra risk involved in buying a quality corporate bond as opposed to a government bond.
But this ‘risk premium’ is now so high it is off the historical charts. An analysis by Invesco Perpetual shows that historically, the average default rate for UK corporate bonds with a BBB rating has been 1.8% and the worst 5.8%, but the default rate implied by today’s prices is a massive 23%- which would require an unprecedented financial meltdown.
In fact, as Paul Read of Invesco Perpetual puts it, the crisis in credit markets is an investor crisis, not an issuer crisis. The companies issuing bonds are making profits and are very unlikely to stop paying interest on their bonds. But investors are still terrified of potential losses. Hence what he and many of his fellow managers see as a great buying opportunity.
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The funds to buy
Though there are many corporate bond funds available, few have good records in recent years- admittedly a very difficult time for managers. My three selected funds are run by managers who have beaten the pack.
Top selection: Invesco Perpetual Monthly Income Plus.
This unique fund holds about 85% of its money in bonds, managed by Paul Causer and Paul Read, and 15% in shares managed by the legendary Neil Woodford. Its success over the years has attracted many followers in the investment community so the fund now has £1,800 million under management.
Causer and Read have made the most aggressive switch of any manager so far from the safety of gilts and triple-A bonds to the B-rated sector, where they now hold 55% of the cash. These managers have got it right more often than any of their rivals over the past decade and if they are right this time, then by early next year you should be sitting on a decent profit.
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Selection * 2: Old Mutual Corporate Bond. In the great bond bull market that lasted until 2006, manager Stephen Snowden produced excellent returns for investors, but at the end of last year he suffered a major setback when the got the market totally wrong. As a result, short-term performance data from his fund looks terrible, but most of the advisers responsible for over £1,000 million of investment in the fund are sticking with it.
Snowden, like Read and Causer, has begun the switch from safety and has about half his fund in B rated bonds. If there’s a strong upturn in the corporate bond sector, Snowden is one of the managers who is likely to max out on returns.
Selection * 3: M&G Strategic Corporate Bond. Richard Woolnough is widely regarded as a ‘safe pair of hands’ and this more cautious fund is one where the managers aim to move from one to another sector of the bond market as conditions change.
With over two-thirds of the fund still invested in A rated bonds and nearly 20% in gilts, Woolnough has not yet made a switch, though he is on record as saying the value is compelling. Like David Roberts at Aegon, he thinks it’s possible that the woes of the banks could cause further upsets in the markets. But he’s clearly ready to move when he thinks the time is right, and though he may not deliver as high returns as my other selections, there’s also less risk.
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