How to excite a bond fund manager

Investors’ confidence in Paul Causer, manager of the £2.2 billion Invesco Corporate Bond fund, is paying off with ballooning spreads and new opportunities resulting from the credit crunch.

Now is the time to switch into corporate bonds. It’s not just that interest rates are falling, although that helps. It’s because the credit crunch has sent spreads all over the place and the opportunities to buy decent-quality bonds at low prices is the best for years.

That is the view of Paul Causer at Invesco Perpetual, who manages £5.5 billion, including the £2.2 billion Corporate Bond fund. It takes a lot to get a bond fund manager excited. But Causer is more confident about the outlook for corporate bonds than at any time in the past decade.

A year ago it was so different. Causer was becoming increasingly bewildered by the compression in yields and the lack of value. Privately, he was telling people there was little reason to commit new money to his fund, but such is his reputation that millions of pounds still came through the door.

What he did was position the fund as defensively as possible – a move that is now really paying off. “We thought markets were looking crazy. We shifted to short-dated investments (such as 12-month bonds) where we knew that we would get our money back. We had more exposure to government bonds, had lots of cash, and avoided long-dated corporate credit risk. Now we are in a position to exploit the opportunities out there.”

If you have not been watching the bond market recently, it’s remarkable what has happened to spreads since the credit crunch hit. The big banks, such as RBS, have widened from 100 basis points over treasuries to about 350 basis points. The ones with a whiff of Northern Rock, such as Alliance & Leicester, have ballooned to 500 basis points.

Non-banking top-quality bonds such as Tesco have seen their spreads double. In the junk bond market, what Causer calls the “safe-ish names” have gone from 200 basis points to 500 basis points, while further down the scale you are looking at CCC bonds at 10% over treasuries.

Usually, spreads of this scale are a sign of deep distress in a market that is anticipating widespread defaults. But although the risk of default has risen, it has not risen to levels to justify such spreads, Causer says. Instead, he points to technical problems from the credit crunch that are creating remarkable price movements and opening up the opportunities he is so keen to exploit.

The technical issues surround an esoteric vehicle called collateralised loan obligations (CLOs), which were the cornerstone of the leveraged loan market. That was the market that provided finance for private equity deals that were the driving force in stockmarket gains until mid-2007.

Causer explains: “The reason why corporate bonds are attractive is not because interest rates have fallen. The real story is the fallout from the credit crunch. The cost of corporate debt has ballooned. We are still right in the middle of the problem. It’s not getting any easier, and in some places it’s deteriorating even further. There’s a huge log-jam in the leveraged loan market because when the music stopped the banks were left with a lot of inventory they haven’t since been able to sell.

“Because of the log-jam, the prices of loans are in free-fall. This in itself is the trigger for clauses in certain structures, which results in an accelerated wind-down. Why this matters is that, although it’s an esoteric part of the market, it changes relative valuations on other things, and other markets have to adjust. There could still be another leg down in spreads.”

Causer says that markets are not functioning well and liquidity has disappeared. But shouldn’t that make him cautious? Quite the opposite, he says. “If you come in at this point in relatively good shape, because you were very defensive before, it’s a great opportunity. If you look at yields, the highest quality or the lowest quality, they have adjusted to such a point where valuations are compelling.”

The last time yields shot out was after the technology, media and telecoms bubble burst. But there was good reason for that, as there were a lot of defaults.

“The thing is, for now at least, we’re not seeing the defaults,” says Causer. “The fundamental picture has not changed. This is about the market being in turmoil.”

What we are likely to see is quite a variation in bond fund returns this year, because those that were not positioned so defensively will be badly hurt by the credit crunch.

Pessimists will argue that Causer might be making a big mistake – that the market is giving us an early warning about a steep rise in defaults. Causer doesn’t see it that way. He says: “The $64,000 question is how bad the macro position is going to get. But a lot of what we are seeing [in pricing] has gone above and beyond where we should be.”

So what does this mean for his portfolio? He sees little value in government bonds, where a flight to quality has pushed yields to levels that are too low.

He is interested in that most bashed-up sector, the banks. There are risks, he says; after all, the market is awash with talk of capital-raising and new issuance from the likes of RBS.

He is also moving down the quality scale, although he says ratings have gone massively out of sync and in almost every category of bonds there are areas of value.

Causer says: “One thing for sure is that there has been a shift in the relative value of bonds versus other asset classes such as property and equity. I’m not saying sell equities, but if you are a strategic asset allocator, you should be looking at the value in this sector.”

The yield on a safe bond portfolio can now easily be 6-7%, while for a junk bond fund you can achieve 10%.

I cheekily ask Causer if I should dump my holding in one of Neil Woodford’s Invesco equity income funds for his instead. He has a rather clever answer for that one. Invesco Perpetual also has its Monthly Income fund and Distribution fund, where you retain a bit of Woodford plus you get a fair bit of Causer.

Right now, that looks like an attractive combination.