Switch to bonds waits on inflation

International banking bail-outs have prompted hopes of a recovery in bond markets. But some AFI panellists are holding back from fixed interest investment while inflation remains high.As the credit crunch seeps into the real economy, some Adviser Fund Index (AFI) panellists are looking with increasing focus at the fixed interest sector.

With the Consumer Prices Index (CPI) figure showing inflation continuing its upward trajectory, it might seem strange to start considering increasing exposure to fixed interest. The international banking bail-out efforts, however, have prompted hopes that the credit crisis that has savagely hit the bond markets over the past 12 months has begun to move into its next phase.

“I’m surprised [at the CPI figure] because everyone else is telling me that inflation is going down,” says Darius McDermott, the managing director of Chelsea Financial Services and AFI panellist. “In the real world, despite falls in commodity prices it still feels like an inflationary environment in the supermarket and at the pump.”

The news of inflation remaining significantly above the Bank of England’s target rate of 2% was a cause for concern as the combination of falling commodity prices and downward revisions to economic forecasts suggested inflation should also follow a negative trend.

James Davies, investment research manager at Chartwell and an AFI panellist, says it is important in these kinds of markets not to react to short-term movements but, over the long term, fixed interest is looking attractive.

“What I want to avoid doing is making decisions based on yesterday’s news,” he says. “There probably will be an increased weighting to fixed interest in the portfolios [in November’s rebalancing] but I was already planning to do that. I think with the fundamentals of the period we’re in you’re going to want exposure to large companies with good balance sheets.”

Davies’ cautious sentiments are a reflection of the difficulties fixed-interest investors have faced as the crisis in financial markets deepened. Following the seizing up of credit markets and the bursting of the “too big to fail” argument with the collapse of Lehman Brothers, default risk has remained a threat.

The Investment Management Association (IMA) Sterling Corporate Bond sector has fallen 10.4% over 12 months to October 14 while the IMA Sterling Strategic Bond sector has performed even less well, losing 12.6%.

Unless inflation starts coming down along with interest rates the attractiveness of the corporate bond market will remain underwhelming. In the short term this is the case, according to Tom Caddick, the head of multi-manager and fund selection at LVAM.

“It’s a tricky one because you’ve got a couple of headwinds at the moment,” says Caddick. “Clearly over the mid-term, inflation will come off sharply, but it depends whether there’s some more to come through in the short term. I think high yield looks unattractive at the moment but there could be value in selected investment grade.”

The recent half-point interest rate cut by the Bank of England was welcomed by the market, but many feel, given the severity of the economic downturn facing the British economy, that the central bank will be looking to reduce rates sharply. This, of course, implies a reduction in inflationary pressures that have prevented the bank from following the example of America’s Federal Reserve in slashing rates to combat sluggish growth.

These signs have encouraged AFI panellists to look again at the prospect of adding to their corporate bond exposure in the near future. As with equity markets, the problem will be timing the move back in.

“With inflation going down, interest rates going down and the spreads we’re seeing, this should all help to increase the appeal of corporate bonds,” says McDermott. “We would certainly be contemplating adding corporate bonds to the aggressive portfolio.”

One dilemma wealth managers face is whether a move out of equities at this stage towards fixed interest will only have the effect of crystallising losses made over the past year. With the bail-out plans announced over the past weeks there are also fears of missing a sustained bounce in equities.

This has been compounded by the continuing risk of investing in a sector that has traditionally been seen as a haven. As Fund Strategy reported (September 22), two F&C Money Market funds had their ratings withdrawn by Fitch Ratings because of their exposure to Lehman’s debt, which the ratings agency downgraded from A to CCC over a weekend.

“It has been a difficult sector to be in over the last year and there is still default risk there,” says Caddick.

Until these concerns have abated it is unlikely that there will be a rush to fixed interest but, as the axiom goes, if everyone is selling out of a sector, that is the time to buy into it. That said, nervous investors are loath to lose any more on their investments and wealth managers are certainly aware of the sensitivities at stake.

“In the fixed interest space you want bond fund managers who really understand companies in the way equity managers do,” says Davies. “People like us must be careful to keep clients informed about what they are likely to achieve and how much risk they are prepared to take.”

The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 18 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see www.fundstrategy.co.uk/adviser_fund_index.html).