Zemek bullish about 50-year gilt proposal

Theo Zemek is lead manager on New Star’s Managed Distribution Fund. She graduated from Yale University with a BA in French Literature and Philosophy, and has a PhD in history from Clare College, Cambridge. Before moving to New Star in 2002, she was chief investment officer at M&G International and before that head of global fixed income at M&G. She was senior fixed income manager at James Capel between 1989 and 1992.

Q: How does the Managed Distribution fund work?

A: The fund is aimed at cautious investors and offers exposure to three separate asset classes: investment grade corporate bonds, higher yielding corporate bonds and equity income stocks. I am the overall lead manager of the fund, but James Gledhill (manager of the New Star High Yield Bond) manages the fund’s fixed income portfolio, while Toby Thompson (manager of the New Star Higher Income fund) runs the equity income component. The overall portfolio will always have a minimum of 60% of its assets invested in bonds, with the remainder in equities.

Q: The fund has been going for over two years. Has it changed much since launch?

A: At launch we held two beliefs. First, while gilts and fixed income looked OK, we thought higher yielding bonds were set for a good run of performance. The fund also launched at a time when equities looked dead and buried, so we thought our equity portfolio would do well. As a result, the fund never had a large exposure to interest-rate sensitive companies; instead, we favoured a more aggressive growth strategy and this paid off in performance terms.

Little has really changed in our view since launch, although we are increasingly looking at upping our exposure to 10-year paper. For some time we have predicted that gilts are too expensive and overbought, and the market seems to have finally recognised this. In February this year, for the first time in 25 years, there were 11 consecutive down closes in the gilt market.

As a result, the gilt yield has been corrected from 4.23% to 4.63%. While we have not altered our exposure yet, we may do so if the market continues to go our way. However, I do remain reluctant to buy gilts unless they are yielding over 5%, and that would require a drop in prices.

Q: How much of a concern are interest rates for fixed income markets?

A: They do remain a concern. The government appears to have borrowed significantly off balance-sheet and, therefore, Gordon Brown’s figures may misrepresent the actual amount of debt in the system. As a result, over the past 12 months the fund has adopted a defensive stance in terms of its interest rate exposure. This has been achieved by holding floating rate notes and shorter-dated bonds.

Q: How positive are you on equities at present?

A: We have been running close to our maximum possible weighting in equities for the last six months. Not only can you get attractive yielding equity stocks, the asset class is shrinking while the bond market is growing. Additionally, the dynamics of the economy are showing reasonable growth and low inflation, and corporate buybacks are increasing, so it is an interesting area.

Q: How has Thompson positioned the equity portfolio as a result?

A: The equity portion of the fund is currently heavily orientated to financials, such as HSBC and Barclays, and is also overweight in transport. As Toby doesn’t believe the housing and consumer sectors are dead in the water, he also holds positions in some hotel and leisure companies. Most recently, he has bought into some industrial cyclicals because he thinks dollar negativity has been overdone. The fund has moved away from defensive sectors such as water utilities.

Q: How does the relationship work between yourself, Thompson and Gledhill?

A: I call it “sausage slicing”. I slice the portfolio into the different segments and tell Toby and James to run their pots of money as close to their own individual portfolios as possible. As we all work in close proximity, we talk throughout the week on all the ideas, although we rarely have formal meetings.

Q: Despite being a cautious fund, the overall portfolio has delivered a return of 35.16% since its launch in March 2003, according to Lipper. Where has the majority of this performance come from?

A: Mainly from equities and high-yield bonds. Going forward, the majority of performance is likely to come from Toby’s equity side of the portfolio. While the investment grade sector is currently witnessing a sell-off, our stance of holding shorter-dated bonds and money market instruments has meant the pain of this on the fund is not as great as it could have been.

Q: How is the portfolio currently split between the different asset classes?

A: Toby’s equity portfolio represents 38% of the fund, James’s higher yield bonds element accounts for 35% of the portfolio, and investment grade corporate bonds take up 25%. The rest is held in cash. The market has been unusual in that all three of the asset classes have seen rises at the same time.

At a time when gilts should have been going down, they have defied gravity by being overbought. However, we are now beginning to see a sell-off in investment grade bonds and as such we have put our backing behind equities. We remain cautiously optimistic about the higher yielding segment of the portfolio, but we are keeping a close eye on interest rates.

Q: How do you regard bonds?

A: While most houses tend to look at bonds on a bottom-up basis, we tend to be more top-down in our approach. For us the most important factor behind performance is getting the interest-rate structure correct. We also think it’s a good to rule out a lot of different credit. We use a number of overlays to do this, one of which is by assessing sectors. Once we find a sector we like, then we do the nit-picking analysis.

Q: What do you think of the government’s decision to issue a 50-year dated gilt announced in last week’s Budget?

A: This is likely to prove really popular. The French government recently issued a 50-year bond, which was massively oversubscribed. The reason for this is simple. Pension funds and life insurance companies have long-term liabilities and a 50-year bond enables them to match these more accurately than they can at present.

There is a shortage of long-dated paper in the UK market and actuaries are pushing institutional investors to buy gilts instead of equities regardless of the yield. As a result, the government could likely borrow on good terms. Whether the issue succeeds will be down to the size of the borrowing, the issue’s liquidity and the absolute and relative yields. However, broadly speaking, it is good news for the evolution of the UK market.