Benefits of a bearish view of banks

Jim Leaviss predicted gloom for banks and kept his M&G fixed interest funds out of them. His funds have stayed buoyant while others have plunged. Now his worries are focused elsewhere.

It has never been a better time to be a doomster. Back in February I interviewed Jim Leaviss, head of retail bond funds at M&G, and was struck by just how gloomy he was on the outlook for banks. He predicted then that it was going to get a lot worse, and was positioning M&G’s funds into government debt at a time when other bond managers were bottom-fishing in the banks. How wrong they were.

Today, Leaviss’s funds are top of the table – and the difference between the top and the bottom performing funds in the various Investment Management Association (IMA) fixed interest tables has never been wider. Leaviss has been in the right place on duration for months, and although his funds have benefited hugely already, he’s not about to switch position.

He says there’s still a lot more pain to come – this time in the real economy, not just in the world of City funny money – and interest rates are going to fall dramatically as central banks stop fretting about inflation and instead watch the jobless figures march upwards.

At the start of the year Leaviss bravely predicted that investors could earn 8-10% in 2008 in his bond fund. He was spot on. M&G Gilt and Fixed Interest Income, an £850m fund on which Leaviss has been lead fund manager since 1998, is up 6.4% over the past year. The European Corporate Bond fund is up 8.6% and the Emerging Markets Bond fund (all run by Leaviss) is up 12.3%. The only glitch is the £1.1 billion Corporate Bond fund, which is ahead just 0.6% over the year. But when everything else is crashing, clients are not going to be arguing about a fund that is still giving a positive return.

Corporate Bond is also a long way ahead of the competition, with first quartile figures over one year and three years. The dispersion of returns in the Sterling Corporate Bond sector is now striking indeed. Only five funds have recorded a positive one-year return, and two of those are from M&G.

The key was avoiding bank bonds, which make up about 40% of the market. M&G’s corporate bond funds have held their weighting at about 10%, while others have gone as high as 50% or even 60% and are looking deeply exposed.

At the bottom end of the table are corporate bond funds from New Star, Resolution, Old Mutual and Axa, which are all showing falls of 15% or more. Try explaining that to clients who thought they were buying a cautious, haven fund. Indeed, some of the funds have the word “cautious” in their title. Expect some fireworks about that in the coming months. And poor old Halifax – not only has it suffered the ignominy of a takeover, its £3 billion corporate bond fund is down 10% over the past year. Funnily enough, its single biggest holding is debt issued by – Lloyds TSB.

Back in February, Leaviss told me that bank bonds were best avoided. Yes, they were priced at yields similar to traditional industrial bonds, but the risks still left him feeling uncomfortable.

“Vehicles such as CDOs [collateralised debt obligations] are still unwinding as we speak. We are not yet at the point of maximum panic in credit markets,” he said, predicting that spreads would widen even further yet. “This is not the time to go downwards into riskier assets … default rates will rise from here on out, and could edge up towards 6% this year. I wouldn’t go hunting for yield over quality just yet.”

Today, his bearishness remains intense. He reckons that we might only be half-way through the falls in government bond yields. “The US government bail-out will pass. But the real economy is tanking. Every day there is more bad news. John Lewis’s numbers were down 8%. People are just not going shopping. US car sales have fallen off a cliff.

“Where does that take you? I think UK interest rates will fall to at most 3.25% and maybe lower. US rates will go to zero. What people are worried about now is not inflation but the real economy.”

He says that “hopefully” the events of the past year have been a once-in-a-lifetime experience. But it will be a long time before we are out of the woods. He is keen to draw parallels with Japan in the early 1990s. “When the bubble burst in Japan, yields on government bonds fell from 8% to 0.5%. We are only about half-way along that path.”

That suggests that huddling in long-duration government bonds will still pay off for some time to come. Luckily for us, he reckons that Ben Bernanke, chairman of America’s Federal Reserve, knows what he is doing. He is a student of the Great Depression and knows that, unpopular as it is, you have to bail out the banks or we all go down with them. And the way to bail out banks is to create a steep yield curve (that is deep cuts in short-term rates) to help them re-liquidate their business.

Republicans who say that a bail-out is unnecessary and that a free market economy must cleanse itself of weaker elements, are taking precisely the same line as the American Treasury secretary in 1929, Andrew Mellon. But his failure to intervene in the market ensured the depression was deeper and lasted longer than necessary. Central banks, says Leaviss, should heed the lessons of the Depression and cut rates aggressively now.

One thing that markets – and politicians – may want to prepare themselves for is that Britain may lose its AAA rating as the liabilities for bail-outs and protection schemes reach gargantuan proportions. The same happened to Japan, but curiously it never dampened demand for Japan government bonds.

One consolation, for the politicians at least, is that the government will be able to finance a deep spending deficit by issuing billions of pounds’ worth of gilts at ultra-low rates – and have no problems in finding buyers. The last time it happened was in 1993, a huge year for government issuance, but it was also a record year for bond performance.