The success of the Close Finsbury Gilt Fund has proved wrong the cynics who did not believe that by writing covered call options, manager Ian Walker would be able deliver extra income and attract both institutional and retail clients
When Close Finsbury first predicted gilt investors could enjoy an enhanced yield by putting their money into its innovative new fund, the claim was met with a degree of scepticism in some quarters of the market.
Cynics questioned whether the idea of writing covered call options would truly deliver extra income and attract both institutional and retail clients who were looking for a safe option with a lively income.
But 12 months on, it is clear the company was right to put so much faith into the project because the UK Gilt Fund has delivered on its promises and millions of pounds have been flowing into the portfolio.
The success has also been a personal achievement for its manager, Ian Williams, because it has vindicated his claims that the fund could deliver a return comparable to that of corporate bonds, but without the associated risks.
"The fund has done exactly what we said it would achieve," he says. "We published a brochure before we launched saying how much extra selling options would add to the total return and that is what has happened."
The overall stated objective of the UK Gilt Fund, which is benchmarked against the FTSE Actuaries Government Securities UK Gilts All Stocks Index, is to provide a level of income and stability of capital growth.
To achieve these goals, it is allowed to invest in UK Government bonds that are over five years in maturity to make the fund fully eligible for Isas. The sub-fund, of course, is actively managed.
The yield is then enhanced through premium income generated by writing covered call options against stocks in the underlying gilt portfolio.
Charteris Treasury Portfolio Managers, the investment management company that specialises in supplying specialist portfolio services, acts as investment adviser to the fund and is focused on managing risk through careful diversification, stock selection, market timing and asset allocation.
It is an investment style that appears to be paying handsome dividends. It has delivered a total return of 6.25% from its launch on 25 October 25 2003 up until 14 October 14 this year, according to data supplied by Close Finsbury.
"The fund is a bit like Arsenal football club," jokes Williams. "It virtually went to number one in its first week and it has been there for most of its life."
These performance figures haven't gone unnoticed by investors who have been eager to plough money into the fund over recent months.
"This fund is now the biggest selling product for Close Finsbury and is bringing in even more money than we anticipated," claims Williams. "We started off with £1.4m a year ago but it is now £22m, even though we've had a flat period over the summer with not much happening at all."
Furthermore, it is hoped the success achieved so far will attract even more investment groups and help increase the fund size.
"Now the fund is over £22m, it will go on a lot more radar screens," predicts Williams. "A lot of people wanted to buy it before but weren't allowed to, due to their investment restrictions. At £40m, it will start to go on some fairly big investment panels and might then end up going straight to £100m."
However, Williams is convinced most of the money flowing into the fund has come from traditional gilt investors rather than people diverting their cash away from equity and bond portfolios.
"I believe more than 90% of the inflows have been substitution money," he says. "It's mostly people who want to own gilts in this fund rather than directly and the reason is the enhanced yield of 2% to 3% it provides."
For most of these investors, particularly those in their 50s who will have up to 40% of their overall investment portfolios in gilts, backing the UK Gilt fund seems a pretty logical argument in light of the extra yield available.
And Williams should certainly know what he's talking about. The chairman of gilt experts Charteris, he has been a member of the London Stock Exchange since 1981 and has spent more than 25 years as a specialist in G7 Government Bond markets, where he has covered sales, research, market making and proprietary trading.
In his opinion, there are seven key benefits offered by the asset class. The first, and most obvious, benefit of gilts, he says, is their relative safety.
"The UK Government has never defaulted on any of its bonds since the inception of the UK gilt market in the 18th century," he explains. "This is in stark contrast to a number of corporates defaulting on their coupon payments."
Prime examples in recent years include the Italian food group Parmalat, as well as Enron and WorldCom, which, Williams believes, highlight the potentially vulnerable nature of the corporate bond market.
It is a trend he believes will continue. As the size of global companies increases, he points out, the impact such large-scale corporate failures have on both the world economy and the corporate bond market will have significant cause for concern.
Next up is the liquidity factor. Compared to their corporate counterparts, says Williams, Government bonds offer unrivalled liquidity - the ability to buy and sell immediately and with relative ease.
Dealing costs are also high on the agenda. Whereas gilts are traded on close bid/offer prices in the secondary market, the dealing spreads for corporate bonds can often be in excess of 100 basis points.
Another key issue is transparency. Gilts, for example, are valued every day by the UK Treasury Debt Management Office. "This ensures consistency and clarity of method and process with regard to their valuation," explains Williams.
The valuations for corporate bonds, on the other hand, can be obscure and open to dealer interpretation.
The fact all gilts have identical, AAA, ratings relative to each other is another useful benefit, he believes. "In corporate bonds, specialist research is required and may result in a variety of ratings," adds Williams. "It is also interesting to note there has been a tendency over the past five years for downgrades to outnumber upgrades in the corporate bond market."
Williams says if investors want to pledge the gilt as an asset for a bank loan, they will be given a much higher proportion, around 80% to 90%, than if they put up a corporate bond as security.
Finally there is acceptability. "Gilts are more widely accepted for investment purposes among the investment community," says Williams. "Friendly societies, charities, personal or family trusts, all of which are governed by trustee law, often demand investment in government bonds only. Investment in corporate bonds is often not allowed for these types of investors due to their higher risk profile."
So with the arguments for investing in gilts clearly listed, how are the individual stocks chosen for the portfolio? Well, the decisions are made through the use of a selection process known as GiltSoft.
This yield curve analytics model has been developed by Patrick Phillips, another investment adviser to the UK Gilt fund, over the past decade. Phillips, who is recognised as a leading Government bond expert, has worked for a string of major institutions, such as Phillips & Drew, BZW and Merrill Lynch.
The author of several books on government bond markets, he was elected deputy chairman of the gilt-edged market makers association in 1986 and subsequently served as a member of the Council of the London Stock Exchange and chairman of its gilt-edged rules committee.
His GiltSoft product is a dynamic real-time model of each of the major government bond markets and works by inserting the expected changes in one-month money rates and 30-year bond yields over a set period.
After this data has been input, the model will automatically re-draw the yield curve to take the new variables into account and then calculate the expected total return for every bond in the market.
Williams predicts the investment style of the fund is designed to work in most situations. Only if the market is roaring ahead, he adds, might it be worth holding actual gilts instead.
"The only scenario where it will under-perform is in a sharply rising market," he explains. "If it's going through the roof then it might be better to hold gilts directly as we're selling a possible rise in the market in exchange for hard cash, which gets added on to the return."
The past year, he reflects, has not been too bad a backdrop for the fund. "An ideal scenario is when the market is quite volatile but doesn't actually end up going anywhere as you get a lot of money for selling the options," he comments.
Looking ahead, Williams expects a fairly unexciting few months. The Bank of England's Monetary Policy Committee might be tempted to put the base rate up once or twice more, he suggests, but nothing too dramatic is on the cards.
"If you had to choose between a bull, bear or stable market, you'd have to go for the stable outlook," he adds. "I don't think there is great potential for movement either up or down."
So why should investors swayed by the gilt story invest their money in Close Finsbury's UK Gilt Fund?
"The key point is that selling options makes this portfolio completely different to every other gilt fund," says Williams. "It enhances the return without the risks or aggravation of a corporate bond fund. That is why it has been selling so well and everyone that has seen it has liked it."
