Needless to say, the credit crunch that gripped the markets in the middle of the year has made some bond investors reassess their strategies. Adrian Frost, co-manager of the Artemis High Income Fund, argues that the summer’s debt market problems have been a ‘wake-up call’. He says, ‘The problems of recent months demonstrated the dangers of investing in opaque instruments such as collateralised debt obligations (CDOs). Recently, our fund’s 0.5 per cent exposure to an equity instrument from Caliber Global Investment brought performance down by 40 basis points for the month. The message has to be “Don’t invest in what you don’t understand.” The capital shock of CDOs, in particular, has been immense.’

Worsening fundamentals

Chris Iggo, senior strategist at AXA IM, feels that ‘Just when you thought it couldn’t get any worse, it did. In recent weeks we have had news of more gigantic losses at US financial institutions, allegations of fraud in the US mortgage market, fears about the financial stability of bond insurers and suggestions that China might start to diversify its foreign exchange holdings away from the dollar. Credit spreads widened out, global stocks fell and the dollar weakened even further.’

Tony Dolphin, head of economics and asset allocation at Henderson Global Investors, points out that ‘Bond yields in all the major markets fell in October as worries increased about the sustainability of economic growth in 2008, especially in the US. Investors now believe that growth can only be sustained if central banks are prepared to cut interest rates in coming months. Although the Federal Reserve is expected to be the most aggressive in cutting interest rates, the fall in yields was uniform across the US, UK and Euro-zone markets.’

He adds, ‘Markets are already factoring in more cuts in US interest rates, so yields may not fall much from present levels in the short term, even if these cuts are delivered. By this time next year, yields could be a little higher if the US economy avoids recession. Rate cuts in the UK might allow yields to fall relative to yields in other economies. We believe bond market returns may be less than inspiring, as markets may have gone a little too far in discounting US interest rate cuts. However, lower interest rates in the UK could boost bond returns.’

Financials attractive

Meanwhile, Robert Ryan, a credit analyst at ABN Amro Asset Management specialising in the European banking sector, believes the credit issued by European financial companies currently offers attractive value: ‘The lack of transparency regarding European banks’ exposure to US sub-prime mortgages and CDOs has led to a sell-off of corporate bonds in the financials sector.

‘We expect more bad news to come out regarding sub-prime and CDO exposure. As such, we do not believe current spread levels, which reflect the market’s estimate of risk, on the bonds of European investment banks offer sufficient reward for the ongoing risks. We prefer retail-oriented banking institutions. This is the most attractive area at the moment because it is the most stable and defensive kind of business during an economic downturn.

‘Another business area I expect to do well in the short term is primary life insurers. Insurers became defensive in their investments following the 2001 correction in equity markets, reducing their exposure to equities and adding to their fixed-income allocation.’