The M&G Corporate Bond fund is eschewing high-yield debt and bank bonds in favour of high-quality debt in sectors such as utilities and telecoms. Inflows are rising rapidly as a result.
Skandia issued some interesting sales figures last week. The top-selling funds over its platform are now corporate bond funds, with the table headed by M&G, which is building a phenomenal reputation in bond fund management. It was started long ago by Theo Zemek, but is now under the control of Jim Leaviss. He’s in charge of M&G’s (and therefore Prudential’s) £60 billion in bonds under management, of which about £7 billion is in UK retail.
The credit crunch is giving bond funds safe haven status. Property funds are wrecked, with only the brave committing new money. Equity funds, even emerging market funds, are looking pricey. Cash looks less exciting now that interest rates are heading firmly down. That leaves corporate bond funds.
Leaviss predicts that investors today will earn a total return of 6% to 10% in 2008 by investing in a bond fund.
But unlike many other bond managers – and Invesco Perpetual’s Paul Causer and Paul Read – he’s not yet ready to commit money to the high yielders. He’s staying firmly in government bonds, worried that we haven’t yet seen the full impact of the credit crunch and firm in the belief that interest rates in the America and Britain are heading down fast.
“It’s all about the credit crunch. There are some really nasty things happening in the banking sector at the moment. We expect global interest rates to fall like a stone. The Fed rate is currently 3% and we think it could get down to 1% later this year,” says Leaviss.
His conviction stems from a belief that the global economy, particularly the American economy, is in a worse shape than most investors realise. “We are probably already in a US recession, which will deepen through 2008 and last to 2009,” he says. “How central banks respond to a weakening global macro-economic outlook is crucial.”
Mervyn King, governor of the Bank of England, is an “old-fashioned puritan”, he says, and wants to punish banks and the financial system for the mess they’ve got themselves into.
King’s counterpart at the Federal Reserve, Ben Bernanke, takes a different approach. Bernanke realises that unless he sorts out the American banking system, the country will be thrown into a 1930s-style depression brought on by the removal of liquidity and the inability of individuals and corporates to borrow.
His answer is aggressive rate cutting. The European response is to worry about inflation. But while Leaviss sees inflation rising to “elevated levels” in the short term, he doesn’t see it as a medium-term problem, given that growth will fall below trend for the next couple of years.
Portfolio-wise, it means Leaviss is telling his managers to avoid riskier businesses that need to borrow to survive. This means avoiding high-risk junk bonds. The flip side is that top-quality, triple-A bonds are attractive. Yes, yields on high-yielding bonds have risen enormously and are now pricing in the prospect of a recession. But although they are closer to fair value, they are not quite there yet, he says.
Bank bonds are best avoided too. They’re now priced at yields similar to traditional industrial bonds, he says, but he’s still uncomfortable about the risks. “Vehicles such as Collateralised Debt Obligations are unwinding as we speak. We’re not yet at the point of maximum panic in credit markets,” he says. Even with triple-A bonds at 200 basis points above gilts, compared with 30 basis points just six months ago, the number of forced sellers in the market means spreads could widen further. “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.”
What he has been buying is British and German government bonds. In mid-2007, 10-year gilts were yielding 5.5%. Now they are at 4.6%, in a flat yield curve where 30-year Treasuries are just 100 basis points lower at 4.5%. to help them reliquidate their business. Unless central banks get it right, it could be a grim decade. Leaviss says the sorts of thing that “should be keeping you awake at night” are the similarities between today’s American economic situation and that of 1989 Japan.
In 1989, eight out of the 10 biggest banks in the world were Japanese. The 1980s had been Japan’s era. But when the asset price bubble burst, it did so spectacularly. Japan government 10-year bonds which had been yielding as much as 8% collapsed to less than 1%.
Leaviss talks of how Andrew Mellon, President Herbert Hoover’s Treasury secretary, believed the 1929 stockmarket crash and subsequent depression was the economy cleansing itself of weaker elements. But his failure to intervene in the market ensured the depression was deeper and lasted longer than necessary. Central banks, he says, must remember the lessons of the depression and cut rates aggressively now.
Meanwhile, bond investors should be in quality stocks “until we are closer to the moment of absolute distress”.
The quality bonds he likes are mostly utilities and telecoms. In M&G’s leading retail bond fund, the £1.1 billion M&G Corporate Bond fund, France Telecom and British Telecom bonds feature among the five largest holdings. The fund is now run by Richard Woolnough, but previously by Leaviss.
Leaviss takes responsibility for the firm’s bond funds, but is named as lead manager on only a few. He took M&G short duration and short credit in 2007 ahead of the credit crunch. Short duration helped, short credit didn’t. But it didn’t hurt M&G’s rankings; the Corporate Bond fund is now first quartile over virtually all time periods.
Flows into the M&G bond funds are rising rapidly, he says. On days of bad newsflow, the funds see particularly strong inflows. Many worried investors are parking cash in M&G High Interest, while they decide where to put it. In my view, corporate bond funds are looking extremely attractive right now, and if you’re at all nervous about a coming recession, M&G’s funds look like the place to be.