Fund Manager’s Response

A diversified portfolio that includes allocations to government, investment-grade corporate and high-yield bonds is central to efficient portfolio management. The model portfolio, as described, achieves diversification both in terms of bond sectors and bond managers, while retaining its conservative nature – making it suitable for a low-risk investor.
However, in deciding allocation changes to these sectors – specifically whether now is the time to move out of the Allianz Dresdner Gilt Yield fund and into the corporate sector – it is necessary to look at current sterling corporate bond valuations and the potential for further gains in prices.
The current yield advantage of sterling investment-grade bonds over UK government gilts is about 0.7%, which is at least a 10-year low. The average corporate yield advantage over gilts has been almost 1.2% over the past 10 years. Should investment-grade bonds return to this long-run yield average, corporates would underperform gilts by 3.6% in price terms, more than offsetting their initial yield advantage.
We believe that at current yields there is little upside potential for sterling corporate bonds to outperform gilts. However, downside risks remain. With corporate yield advantages currently at record low (or expensive) levels, the expectation of improving global growth may already be fully discounted in the corporate bond market. Should economic growth slow or should there be additional accounting scandals or questions of corporate management, we would expect sterling corporate bonds to underperform gilts.
This is where diversification becomes important and where gilts act as protection against the unexpected. The current portfolio already has significant investment-grade and high-yield corporate credit risk. Adding more credit risk when the markets are paying the lowest risk/return trade-off in recent history is not appropriate for a low-risk investor.
However, should the investor decide to change his risk profile from low to intermediate risk, consideration should be given to overseas markets, or a diversified fund containing UK, European, US and Asian corporate bonds. Gaining exposure to these markets will provide additional yield, with the added benefits of greater portfolio diversification and a wider corporate opportunity set. The Allianz Dresdner High Income Bond fund seeks to employ the firm’s best global credit strategies, taking advantage of global opportunities while recognising the importance of capital preservation.