Fixed IncomeMay 9 2013

Key trends to watch

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However, this created the problem of how to generate returns that would at least provide protection from inflation.

Following promises by Mario Draghi, the president of the European Central Bank, to prop up the euro, investors felt reassured that this break-up risk had substantially reduced and embarked on a hunt for yield.

As a result, corporate bonds, and particularly high-yield bonds, have enjoyed impressive gains.

It is perhaps no surprise that this period has coincided with a sharp rise in the popularity of bond funds that can capitalise on both trends. The ability for strategic bond funds to allocate risk using the whole of the bond market has understandably become a major attraction.

The IMA Sterling Strategic Bond sector has expanded rapidly, and – with assets of £42bn – is now second only in size to the IMA Corporate Bond sector.

However, with gilt yields bumping around close to record lows and many now voicing concerns about a corporate bond bubble, how will bond fund managers make money in coming years?

In my opinion there are several key trends that a strategic fund manager can exploit.

First, the importance of stock picking will come to the fore. Since 2009, the trend has very much been your friend. It has been enough to generate returns simply by taking exposure to the corporate bond market as a whole and high yield in particular.

However, yield spreads over government bonds have narrowed considerably over this time, increasing the risk corporate bond investors face from rising government bond yields. This emphasises the importance of researching individual stocks. Finding companies that could be upgraded or face positive event risk will help to offset the impact of rising yields.

A strategic fund can also take more relative value trades, being short one company and long another – typically in the same industry – so market risks are minimised.

Increasingly, investors will also have to be wary of specific event risk. The recent upturn in risk appetite is leading to a rise in corporate activity. This does not always mean good news for corporate bond investors if deals are financed by more debt. The recent takeover of Heinz by Warren Buffett is a case in point. The deal will result in the global food giant doubling the amount of debt on its books and spreads in Heinz increased by a factor of four from circa 50 basis points to around 200bps immediately after the deal.