The corporate bond market is a relatively recent creation, born from the desire of companies to have access to alternative sources of borrowing to their banks and encouraged by the development of a tax regime that established a more even playing field between equity and corporate debt.

And yet corporate bonds remain a mystery to many. ‘Investors should realise that there are essentially two elements to bonds: duration and credit risk,’ explains Richard Woolnough, manager of a number of bond portfolios at M&G Securities, including the M&G Corporate Bond Fund.

He adds, ‘When considering duration, you need to look at the macroeconomic factors that are going to affect the market over the longer term, while credit risk is simply a question of assessing whether or not you are going to get paid back. These are the two things that concern bond investors and they really are held together by your macroeconomic view as, quite often, what is happening to the market is a factor of macroeconomic trends.’

A bond market veteran
An economics graduate from the London School of Economics, Woolnough has been involved in the bond markets since the mid 1980s and has been a sterling bond fund manager since 1987. He joined the fixed interest desk at M&G in 2004.

As the fund management arm of major insurance group Prudential, M&G devotes considerable management resources to its bond funds. Woolnough explains,
‘We are the largest manager of credit in the UK. Our credit team is one of the largest in the City, so we have considerable resources and huge economies of scale, and I can access that pool of expertise. It would be quite difficult to do it all on your own because of the complexities of the market.’

However, he also points out, ‘I have been investing in corporate bonds for 20 years, so I suppose you could say that I have grown up with the market. The major difference is that it is a much deeper and more liquid market now, and there are far more issuers than there used to be.’

So how does he approach the management of some very large bond portfolios – M&G Corporate Bond alone is £1.1 billion in size – and how does his approach differ from that of an equity fund manager?

Woolnough’s reaction to the latter question is, ‘You generally find that there is more optimism with the equity guys and more pessimism with us, as we have to stick to the macro approach rather than stockpicking. If something is going to impact on a particular sector then it is going to be felt by all the bonds within that sector.’

A top-down approach
He adds, ‘The macro view drives what you are doing in terms of asset allocation, so I am very much geared towards taking a macroeconomic view and then working with the team of analysts here at M&G to find individual investments that meet that view.’

However, this process is not as straightforward as it may seem. ‘You have to invest in what is available that most closely fits with your view. It is not an infinite market, so you have to compromise to create the kind of portfolio you wish to see. The bond you really want to have in your portfolio may not exist in terms, for example, of the right duration, so you have to invest in what you can actually buy.’

Woolnough explains his construction of a portfolio in terms of the human body. ‘When you are constructing a portfolio, the duration views form the skeleton and the credit risk are the muscles. Then the actual stock selection is the skin over the top of all of that.’

Global coverage
Another aspect of the M&G Corporate Bond Fund that investors may not appreciate is that, although it sits in the UK Corporate Bond sector, it is not restricted to investing in bonds issued by UK-listed companies.

It can hold government securities as well – in fact, the largest current holding is a gilt – and the key factor in determining his universe is that it comprises bonds issued
in sterling.

Woolnough observes, ‘One of the views we have been following is the slowing of the US housing market, and it would be difficult to know how to take advantage of that in a UK equity portfolio. But what happens in the bond world is that your universe is not dictated by where the capital was “born”. The corporate bond market doesn’t work like that. You have companies all over the world issuing in sterling, so we don’t really pay attention to where a company is based.’

He adds, ‘My index is not full of UK issuers. It is full of international companies that need to raise capital in sterling. So, compared with the average equity fund manager, I have a much wider palette to choose from. For example, if we see that the US housing market is in crisis, then we react to that by not owning US banks.’

Woolnough says, ‘If there is something we don’t like, we tend to discard it. So, for example, with US banks, it was not a case of going underweight, we just don’t own any at all. As bond fund managers, if we really like something there are also constraints, so that we are not too exposed to any one area.’

He underlines another key difference between bond and equity investors. ‘We take this approach because, in the bond market, if you get it right you make one or two per cent, but if you get it wrong you can lose 50 per cent very quickly. So I like to keep the portfolio nice and clean and risk averse. It is in my nature to keep away from areas that I don’t like.’

Reacting to major events
Woolnough explains, ‘Being a bond investor, if a company’s earnings come out ten or 20 per cent better than expected, while equity investors will get very excited, bond prices will hardly move. That is why we concentrate on more macroeconomic themes. We tend to sit further back than equity managers. It is the events that will make the share price double or halve that will also move the bond prices, and it is these kinds of events that we are interested in.’

Which explains why Woolnough and his colleagues place so much store in getting their macroeconomic views right. ‘There are times when the market is dull and there is very little activity, while at others there will be a lot going on. I am a firm believer that the economy responds with lags to different events. The market slowly reacts and moves to reposition itself and you try to take advantage of that process. So you take a view of different corporate bond sectors in a similar way that an equity fund manager would.’

But there are crucial differences from the approach of his equity colleagues. He points out, ‘I will attend company meetings, but usually when a company is about to become distressed or because I want to get a wider view of its sector. And I don’t just look at
one issue. In some economic environments we will be focusing mainly on credit risk but in others we will focus on duration. At different times in the cycle different factors will have a significant effect on how the portfolio performs.’

Horses for courses
Turning to the question of how many bonds he holds, Woolnough says, ‘The number
of holdings in the fund is determined by the nature of the mandate. Corporate bond funds are generally conservative and so tend to be broadly spread, but I also run the Strategic Bond fund, which is focused down to about 50 or so.’

He adds, ‘If you have a portfolio that is mainly investment-grade or AAA bonds, then you probably don’t need so much diversification, whereas with a lot of BBB- and C-rated holdings, you need to spread the risk a lot more. It is like an equity fund manager running a large-cap fund who feels that it can be more concentrated compared to a small-cap portfolio, where he would need to diversify a lot more to spread the risk.’

Woolnough also stresses the importance of maintaining a constant watch on a bond portfolio. ‘By definition, the economic cycle tends to be shorter than the life of a particular bond. The portfolio reflects your views at a particular point in time, but those views will change. You recognise those that you think are cheap and you hope that the market will catch up with you.’

He points out, ‘The effect of the credit crunch has been a marked drying up of credit.
We have reacted to that by avoiding the weaker banks and concentrating on the better-quality banks. Having said that, we reduced our overall exposure to banks when the credit crunch hit and found better homes for our money than the financial sector.’