Credit crunch reverses gains of first six months

2007 was a year of two halves for funds in the UK Other Bond sector, split by the credit crunch at the height of the summer.

At the start of the year, bond investors were revelling in the gains from high yield but saw this quickly unravel when banks stopped lending to each other following the US sub-prime crisis in early July.

Some managers have admitted their performance has been hurt by holding too much high yield, or junk, debt but many have managed to come out the other side of the credit crunch and still produce healthy gains.

Although the IMA guidelines state at least 20% of assets must be in below triple B-rated bonds, most managers said holdings in gilts and cash helped protect investors' capital.

High-yield issues

Chris O'Hare, manager of the £112m Investec Monthly High Income fund, said that throughout 2005 and 2006, high yield was a strong sector and funds overweight in that area did well, particularly if they were exposed to the lower-rated end of the market.

"We have since seen this reverse to some extent" he said. "It started to come in June and July with the start of the US sub-prime credit crisis and since then funds with more in gilts have done better."

His fund, which he runs with Kieran Roane, is one of the top performers in the UK Other Bond sector over one and three years.

Over three years to 17 December 2007, the fund has delivered 13.76% growth bid to bid, outperforming the peer group average of 10.22%, according to Morningstar.

O'Hare attributes the performance largely to asset allocation.

"In 2004, we had 100% in high yield so were quite aggressive although it was also risk-adjusted, " he said

"In 2005, we became more cautious and went underweight on CCC-rated bonds, although in hindsight this was a bit too early.We continued to get more defensive over the next two years."

The fund now holds around 60% in high yield, 10% cash and the remainder in investment grade bonds and gilts.

O'Hare said the fund benefited from a number of emerging market corporate bonds over 2007, such as Russian mobile phone companies and steel producers.

"These have been able to withstand the storm better than European high yield but our outperformance is as much about not holding the problematic bonds. The credit crunch only affected us indirectly," he added.

At the time of the crunch, the fund did not have much financial or housebuilders exposure and O'Hare has never invested in structured credit.

O'Hare said he is probably more bearish than his co-manager Roane on the future of the markets but believes it will be a lot clearer at the end of the next quarter.

Banking struggles

Elsewhere, the £578m Standard Life Higher Income is another consistent performer in the UK Other Bond sector.

Over three years, it has returned 17.44% compared to the average of 10.22% and one-year gains are 0.18% while the sector made an average loss of 1.06%.

Managers Erlend Lochen and Alasdair MacLean admit the disruption in the banking market has been a struggle for the fund as risk has been re-priced and credit spreads widened.

Lochen said that while default risk had been quite low at 1%, it is expected by some to rise to 4% to 5% in 2008.

At the beginning of 2007, he held as much as 90% in high yield but reduced this to 75% by the end of June and now holds around 70%.

The rest is a mix of gilts, cash and investment grade.

Lochen said the fund's performance has mainly come from holding gilts and cash.

"Stock selection has been key in avoiding too many blow-ups and our limited exposure to banks, that some of our competitors took on, has helped," he said.

He added that a view on markets in 2008 depends on whether you believe there will be a US recession.

"If there is a recession, investment grade and high yield will sell off further and default levels will rise," he said.

"If there is no recession, at the current levels the spread in high yield is probably fair value but, technically, investment grade is a bit more unclear.

"For 2008, stock selection is going to be even more crucial than before."

In the one-year figures, Schroders Strategic Bond fund sits at the very top of the sector, returning 2.96%. It has also outperformed over three years, returning 11.51%.

Manager, and head of fixed income at Schroders, Bob Michele uses a best ideas approach on the fund and is unconstrained by the benchmark weightings.

Positions are generally hedged to protect against currency movements unless an opportunity to take advantage of foreign exchange moves appears.

Last year, Michele said that the exposure to US markets had hurt returns.

"During the third quarter of 2007, the investment climate was more volatile and our positioning in certain areas, particularly with regards to the US bond market, detracted from returns," he added.

He is concerned about the fall-out of the credit crunch, particularly in the corporate bond market, even saying it is enough to trigger a US recession.

"Some people are taking a view that the US is probably already in recession, an opinion which probably is not unreasonable," he added.

"In short, interest rates are too high and they must come down. This is a scenario which is positive for government bonds, particularly short-dated bonds.

"The history of financial crises always coincides with aggressive rate cuts from central banks and a sharp increase in demand for short-dated bonds. The current crisis is a textbook example of that."

However, he also added that while rate cuts are ultimately good for corporate bonds as it strengthens a company's ability to repay its borrowings, it is going to be some time before this materialises.

He said that while corporate bonds have got cheaper recently, the prices do not reflect their negative outlook.

"The pipeline for new bonds, especially high yield, has taken a hit and will continue to do so," he said.

"The uncertainty in the market is such that deals are being pulled all the time. Companies are recoiling from the high borrowing rates, and investors are baulking at the quality of companies' finances."

Other funds that have performed well in the UK Other Bond sector over both one- and three-year periods include Invesco Perpetual Monthly Income Plus, run by Neil Woodford, Paul Causer and Paul Read, Marlborough's High Yield Fixed Interest fund, which is outsourced to Aberdeen's Paul Reed, and L&G High Income.

Categories: Managed | Fixed Income | Offshore Investment | UK | Equities | Investment

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