More flexibility needed as ‘free lunch’ ends

John Pattullo, manager of the Henderson Preference & Bond and High Yield Bond funds, says that 2004 will be a difficult year for investment-grade bonds and bond fund managers will have to be more opportunistic in their asset allocation.
Pattullo positioned his fund towards high-yield bonds in 2003 as the high-yield sector is less exposed to interest rates and more exposed to default rates. However, he is now becoming more negative on the sector and is starting to move his funds into cash or gilts at the margin.
The “free lunch” in bonds is over, according to Pattullo. He believes that while it was easy to make money last year, bond managers will need to be more flexible in their asset allocation this year. Pattullo still likes preference shares, despite admitting that they are illiquid and unfashionable. He says that they give a good yield and are issued by UK-regulated banks.
Pattullo is still negative on investment-grade bonds: the spreads over gilts for investment-grade corporate bonds narrowed so much in 2003 that there is “not much to go for” in 2004. He adds that the absolute yield is also not attractive relative to other asset classes. Pattullo believes that many investment-grade-only bond funds are offering nothing more than a “gilt proxy” fund once charges are taken into account.
The equity/bond balance has shifted. Pattullo says: “We are in a low-inflation market. You can’t get really bullish on equities without inflation. Bond funds offer a consistent and reliable source of income. There should be much less volatility in bond funds – you can’t make or destroy capital as quickly.”