Caution on bonds after 2007 surge

The performance gap between equities and bonds closed significantly as stockmarkets were hit by the credit crunch. But managers appear reluctant to increase bond weightings further.

Bond funds have done little to excite investors over the past five years. The FTSE All-Share index generated double-digit returns in each year from 2003 to 2006, as equities benefited from largely stable macroeconomic conditions. Bonds, meanwhile, suffered as the major central banks raised interest rates in a bid to moderate growth and prevent economic overheating.

According to Financial Express, the Investment Management Association’s (IMA) Global Bonds, UK Corporate Bond and UK Gilt sectors all posted negative returns in 2006. Within fixed income, only UK Other Bond produced a positive return at 4.58%.

However, the performance gap between equities and bonds closed significantly last year, as the stockmarkets were hit by tighter credit conditions.

The year started poorly for fixed income and, once again, UK Other Bond was the only sector in positive territory between January 1 and June 30. British equities continued their strong run, generating more than 7%. But the second half of the year saw a sharp reversal as the All-Share fell by 2% and the Global Bonds, UK Corporate Bond and UK Gilt sectors all performed strongly.

Iain Buckle, an investment manager in Aegon Asset Management’s fixed income team, says higher-quality and government securities have benefited in particular.

“There was a knee-jerk widening of credit spreads and high-yield bonds performed well when the credit crunch kicked off,” says Buckle. “It is a financials-led crisis and the bulk of the high-yield market is not in financial companies – most are industrials. But that started to unwind at the latter end of 2007 and high-yield and corporate bonds were hit more aggressively.”

As a result, the UK Gilt sector made a total return of 8.32% between July 1 and December 31, compared with just 2.91% from UK Corporate Bond. Buckle says Aegon’s £200m Global Bond fund, which appears in both the Balanced and Cautious Adviser Fund Indices (AFIs), has a 25% weighting to government securities. “This is the highest it has been for some time,” he adds.

The fund has increased its allocation to higher-quality financials, including HSBC and Royal Bank of Scotland, which Buckle says have been oversold.

Aegon Global Bond was chosen a total of nine times during last November’s AFI rebalancing. James Davies, investment research manager at Chartwell, uses the fund for his clients but says his AFI “fund of choice” is Old Mutual Corporate Bond. The £1 billion portfolio is the most popular fixed income fund in the AFI, with 12 selections. Davies adds that he is also interested in bond funds that are able to use derivatives, such as Richard Woolnough’s M&G Optimal Income portfolio.

However, while he says that he is “reasonably positive” on the outlook for bonds in 2008, Davies will not be increasing his weightings in the near future. He says: “Of the three principal asset classes, higher-quality bonds have not done badly since last July. We would move into bonds if we expected falling equity markets. But our view is that there will not be a bear market this year, although it may feel like it at times.”

Davies says Chartwell prefers to use institutional structured products as a bond proxy where income generation is required.

Buckle is also cautious on fixed income and says it is difficult to see bonds making further progress in the short term, although he is more downbeat than Davies on the American economy. “Our view is that the US will probably go into a recession,” he says. “Hopefully the easing of interest rates will be enough to stimulate growth and it will be fairly short-lived – there has been a reasonable response from the Fed so far. But the housing market is likely to remain weak and that will feed through into jobs and consumer spending.”

Aegon expects American interest rates to bottom at 3% this year. But Buckle says the firm’s negative economic outlook has already been priced into the bond markets, leaving little room for yields to fall further.

In Britain, Buckle says the markets are expecting interest rates to fall by just half a point, to 5%. He points to greater robustness from British housing, lower levels of consumer borrowing and a greater reluctance from the Bank of England to be “accommodative” in its monetary policy.

Away from the more established economies of the West, Buckle is cautious on emerging market debt, despite its initial rally at the start of the credit crunch. He says: “The theory that the emerging markets are decoupling from the US is interesting. They are certainly more self-sufficient and commodity rich, and this has driven an improvement in their credit profile. But goods produced in China still end up in the West. It cannot remain isolated for long.”

Two fixed income funds – Baring BAM Index Linked Bond and Standard Life Corporate Bond – joined the AFI in November, after they were chosen by one adviser. However, Aegon Sterling Corporate Bond, Baring Directional Global Bond and New Star High Yield Bond were all ejected from the index.


The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 19 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see