Glass: How I am positioning my strat bond fund for 2012

City Financial’s Graham Glass explains where value can be found in fixed income markets in 2012.

With government bond yields currently trading at all-time lows, the risk/reward for holding a significant proportion of this asset class within a portfolio does not feel justifiable.

Credit markets, on the other hand, are pricing in an economic downturn of greater proportions than we have ever seen in 100 years. There is little doubt an experienced global fixed income manager who has a flexible mandate that includes credit, could provide investors with a shelter for their low risk assets. 

Of course, positive performance can never be guaranteed, but the dual strategy of reducing interest rate risk to levels that will not automatically create capital loss in the event of substantial rises  in government yields, while also providing selective credit exposure, should be an attractive approach for the fixed income investor.

Many investors fear credit risk, as recent indiscriminate selling of assets within this allocation of fixed income investment has resulted in poor capital performance.
I believes investors are now being given a great opportunity to invest in this asset class at historically cheap levels.  

The implied default rate on European investment grade corporate debt stands at a double digit percentage, implying an extremely high default rate level in companies during the next five years. 

Even at the height of the Great Depression in the 1930s, the rate was less
than 2%. With a large proportion of a credit bond’s valuation composed of the underlying government yield, unless the fund manager reduces this interest rate exposure by using interest rate futures, capital values could be at risk. 

Within the City Financial Strategic Global Bond fund this is exactly what we are doing. The fund has effectively adopted the Barclays Capital Global Aggregate index (GBP hedged), which has credit exposure within the index.  This could help drive overall positive returns, whereas a pure global government fund could struggle to register any gains during 2012. 

While it has the ability to deviate from the benchmark, the guidelines hope to ensure that the potential large volatility seen within funds that have negative duration positions could be avoided.

The base currency of the fund will remain sterling, but up to 20% of the fund value can be invested in other currencies on an opportunistic basis.   

The credit exposure within the fund is focused on issuers with strong fundamental financial characteristics. 

There are undoubtedly many individual bonds that are offering extreme value.  Issuers such as Marks and Spencer in the UK have strong cashflows and stable turnover, even during a period in which consumer spending has not been particularly strong.

Its GBP bond maturing in 2019, is currently offering a yield of approximately 5%, some 3.5% above the equivalent gilt yield.

Other aspects of the fund which could be prevalent during the early part of 2012 are an avoidance of European financial debt due to the continued uncertainty facing the region. 

Selective exposure within financial issuers of Anglo-Saxon origin may be held.  Senior bonds in HSBC, Standard Chartered and Nordic Investment Bank are examples of strong institutions that may feature within the fund in the coming months.

My current forecasts are for no change in short-term rates, but the initial fund positioning has a low duration compared to the benchmark, because yield curves, especially in the UK and the US, are likely to steepen to historically high levels approaching 3% from their current 2-10 year levels of 1.5%.

Another theme which will be seen within the fund is a relative underweight to Japanese government bonds due to the massive refinancing risk within the country. 

Yield movements are expected to be muted in JGB bonds until a “credit event” triggers a potential sharp fall in bond prices, as has been seen in peripheral Europe.

Graham Glass is new lead manager of the City Financial Strategic Global
Bond fund.