Bonds strengthen in flight to safety

John Pattullo, manager of the Henderson Strategic Bond fund, slashed his exposure to cash and hoovered up subordinated banking bonds in the wake of the market turmoil.

If Bill Mott is the man making a brave bet on banking shares amid the market turmoil, his equivalent in the bond market is Henderson’s John Pattullo. While Northern Rock has been the only story in town, few have paid that much attention to what is happening in the bond market.

But Pattullo, who runs the Henderson’s £700m Preference and Bond fund, plus the racier £180m Strategic Bond fund, is confident that represents a terrific time to fill your boots with the bombed-out investment grade bonds of British banks. These bonds have had a torrid summer. Take, for example, Barclays’ subordinate bonds, where the spread over gilts has doubled from 1.4% to 2.8%. “Banking bonds have been sold off quite aggressively. In percentage terms it has been quite a savage move,” says Pattullo.

It has indeed been one of the most extraordinary few months for bond traders for a decade. The first half of the year saw sovereign (government) bonds weaken amid rising interest rates as the market fretted about overly-strong growth and a lot of hot merger and acquisition and management buyout activity.

Then in July we moved from what Pattullo calls a “reflation trade” into a “recession trade”. In the flight to safety, sovereign bonds became the place to be. “It was essentially a panic, as we moved from euphoria to pessimism,” says Pattullo.

Credit markets recovered a little in August, only to take a further bashing in September. American bond markets have started to recover again, although in Europe, because of the Northern Rock effect, any bounceback is less detectable.

“Markets were, to put it frankly, shut for most of August. But we have started to see even some leveraged loans now getting placed, although admittedly very cheaply.”

The Federal Reserve’s half-point rate cut was the comfort blanket the American market was looking for, says Pattullo, although he wonders about its efficacy.

He echoes Bill Gross, an American bond guru, with his punchbowl metaphor. “Bill Gross talked about the punchbowl being taken away from the party. Well, it is 4am and the Fed has put the punchbowl back in the party, and we haven’t even had time for a hangover. We are already back to the reflation story,” says Pattullo.

Credit markets rallied after the rate cut, but at the long end the curve has steepened – indicating that the market thinks the Fed is taking a risk with inflation.

“Cutting rates is the easy option. But economic history is littered with central banks being too accommodating. How often can you bring the punchbowl back to the party?”

That said, if we can put aside longer-term worries, investment grade bonds are a great buy, says Pattullo.

“In June 2007, we described investment grade bonds as a waste of time, however, the tides have turned and they are now the cheapest they have been in five years and represent compelling value.”

Back in June the top-rated investment grade bonds were selling for a yield of about 0.6% over gilts. That meant that investment managers were charging about 1% to get a 0.6% better return than could be obtained from investing in gilts direct. To people like Pattullo, it just didn’t add up. To most investors, bond funds haven’t added up for some time now. In 2006 they were down about 0.7% and this year they are at best flat. Now, though, the outlook is a whole lot better.

Pattullo kept relatively high cash levels in the Strategic fund – about 10% – for much of the year, and raised it to 20% during July and August. That has helped the Strategic bond fund into first quartile position in the heterogeneous “Other Bond” sector over the past year (although Preference and Bond fund has been a poorer performer).

Over the past few weeks Pattullo has reduced his cash position and has been buying up the banks. “The current shake and re-pricing of risk to more rational or even cheap levels is a good opportunity for bond investors and we particularly favour subordinated banking bonds.

“Buying bonds at the peak of a UK banking crisis has its risk, but we are getting paid for taking risk. We will be adding risk in both funds and fortunately we have significant cash positions to enable us to do this quickly.”

Duration (interest rate risk) is a tougher call, says Pattullo. The 10-year gilt yield is about 5% which is neither cheap nor expensive. “Going forward, sovereign yields are reasonable to cheap, credit spreads are reasonable to cheap, so we are buying risk.”

Pattullo compares the crisis to the Asian financial crisis, the Russian debt crisis, and the aftermath of September 11. In other words, it is grim, but the world’s not going to end. There are still some nasties to emerge – for example, Pattullo has put in place a few shorts against the Icelandic banks – but the risk of defaults is not as bad as some of the rating agencies are forecasting. Some are saying that the default rate will be heading up to 4%. “Given where we are already in the year, that would mean we would need quite a lot of defaults to get there. It’s not looking likely,” says Pattullo.

One lesson from recent years is that credit markets can trade relatively strongly even if part of the market becomes a toxic no-go area. We saw it the early part of the decade in telecom bonds and we will continue to see it with mortgage-backed securities, but it needn’t hurt the rest of the market.

Pattullo expects there to be further cuts in rates in America while in Britain base rate has peaked and the next move is likely to be down. In recent weeks, as deposit rates have hit 7%, it has looked like a no-brainer for investors to park their cash at the building society. But now that the rate cycle has turned, Pattullo is confident that bonds will at least equal and more likely beat cash over a 12-month view. For a long time, all asset classes – equities, bonds and property – have looked expensive. Now at least bonds are looking good value.


The Guardian Personal Finance Editor