John Pattullo, manager of the Henderson Preference & Bond Fund and Strategic Bond Fund expects a positive year for bond returns in 2008 after 2007’s uncertainties. ‘Bonds are looking cheap,’ he says. ‘A general rule of thumb is that you want to buy bond funds just before interest rates peak. Well, rates have peaked.’

He adds, ‘Secondly, corporate bond spreads have blown out to five-year highs and the market is currently trading at levels discounting a recession. In fact, BBB-rated companies are trading at levels discounting five-year cumulative default rates of ten per cent. The worst ever five-year period since 1970 is 5.4 per cent, and the average is 1.9 per cent.’

Financials attractively valued
Pattullo sees particular attractions in the financial sectors. ‘Financials are trading at levels implying 14 per cent default rates over a five-year cumulative period. This is cheap on any risk-adjusted basis. We believe world growth will slow and interest rates will keep falling, and therefore we favour longer duration. Investment-grade bonds look cheap, especially financials. We think secured loans are also cheap, but we struggle to get too excited by high-yield, which we believe is roughly fair value.’

He points out that, ‘Everybody thinks investment-grade financials are cheap, but few are brave enough to buy them now, as most expect them to get cheaper as new supply hits the market in the first quarter of 2008. However, virtually all the strategists believe that, on a 12-month view, this is “trade of the decade”. We believe the current crisis is being contained by equity support by sovereign wealth funds from players such as UBS, Citigroup and, of course, significant central bank action from the European Central Bank.’

Pattullo concludes, ‘There is much to be concerned about with such an uncertain economic outlook, but we believe the flexibility we have in our strategic fund should enable us to steer through muddy waters. We think bonds are cheap and should outperform cash in 2008.’

Exercising caution
However, Stuart Tyler, senior investment analyst at Lincoln Unit Trust Managers, argues that bond investors should probably go on the defensive. ‘Default rates have been at all-time lows in recent years, in the region of one per cent globally for non-investment-grade bonds,’ he says. ‘Many forecasters expect the default rate to reach five per cent in 2009 as a significant number of companies go bust. The Lincoln Corporate Bond Trust has raised its exposure to gilts in recent months and is now much more defensibly positioned at the start of 2008 than a year ago.’

Emerging strengths
What of the emerging markets? Peter Eerdmans of Investec’s emerging markets debt team argues that ‘Two economic questions dominate the markets: will the US fall into recession, and will inflation continue to go up in 2008? If the answer were to be “yes” to both these questions, emerging debt would certainly struggle.’

But he adds, ‘We are still in the camp that expects the US to avoid recession, thanks to an accommodating Fed, among other things, and we believe inflation should be under control – and probably falling – in the latter half of 2008. If we add to this the economic and financial resilience of emerging markets, we are expecting a decent year.’

Eerdmans says, ‘Demand/supply factors are likely to remain supportive for the market. We expect local currency emerging market debt to see strong flows this year as this investment class is “discovered” by more institutional and retail investors. The planned US$5 billion (£2.55 billion) World Bank-sponsored fund will add to this.’