Ignis Corporate Bond and Ignis Absolute Return Credit manager Chris Bowie thinks creeping inflation will eventually trigger a rise in gilt yields which could inflict serious capital losses on corporate bond fund managers.
Citywire AA-rated Bowie, who was ranked 14th in the Citywire Top 1000 manager analysis, and co-manager Adam Walker, have been defensively positioned for some time as they wait for this scenario to play out, shunning financials, cutting duration and preferring asset backed securities such as the fixed income bonds held by supermarkets. The corporate bond fund has just 10% in gilts and around 7% in cash.
While the pair think that over the short term corporate bonds still offer attractive returns, that scenario could change very quickly and the fund has around 18% in asset backed securities, almost twice the level of the benchmark index.
Inflation will trigger gilt yield rises
The duo, who are in the process of making the corporate bond fund available to European investors, believe the adjustment, when it comes, will be painful for credit investors and that it is likely to occur within months, not years.
Bowie said: 'When it comes, fixed income returns will be hit hard. As a general rule, credit loses 7.8% of its capital for every 1% move higher in gilt yields. Ten year real yields on gilts are about -1% and the long term average is 3%.'
'If it goes back to the long term average that is a capital loss of 30% so we think all the risks are on the downside.'
Bowie said that the launch of the Ignis Absolute Return Credit fund last July had been partly to deal with an eventual rise in gilt yields and subsequent capital erosion.
The new fund targets cash plus 5% and uses pair trades, tending to be short on cyclical and long on less cyclical names. The £75 million fund has sterling, US dollar, Swiss franc and euro share classes.
Bowie told Citywire Wealth Manager: 'For now, wage inflation is not an issue in the UK and consumer prices have fallen from recent highs but I think real yields on gilts will adjust back up towards 2.5% within the next few months.'
'As long as persistent deflation does not occur, real yields will adjust upwards. It will certainly not be years away.'
Bowie and Walker have been positioning the fund to deal with this eventuality, and also for the possibility of a eurozone break up or further banking crisis.
'We have minimum exposure to financials and consumer related bonds and prefer supermarket bonds which can provide the reassurance that if they did default, the bond holders would have the right to their assets, be it machinery, property or land.'
Three of the corporate bond fund's top 10 positions are in bonds issued by Sainsbury and Tesco, which invest in the property portfolios of the supermarket chains.
'We can buy unsecured Tesco or Tesco property bonds which have a higher yield than normal corporate bonds.'
Co-manager Walker said some tactical risk had been added in 2012 through bonds in peripheral European telcos such as Spain's Telefonica and Telecom Italia which the pair felt had been unfairly punished due to their respective countries of origin.
They have also added lower tier two debt in Crédit Agricole bonds which they bought last June as the pair thought it had been marked down too harshly due to its exposure to Greek debt.
The fund also has around 10% in floating rate bonds where the coupon is reset every three months.
'In one of the next five years we expect double digit losses for credit so we can use these floaters to protect against that.'
The fund now has just 3% in peripheral utilities, down from 10% a year ago and profits have been taken in a raft of insurers.
Having learned the lessons of 2008 when Bowie inherited a portfolio overweight on banks which quickly became illiquid, the fund remains heavily underweight banks and has just 20% in financials as a whole, compared to the benchmark's 30%.
Bowie said: 'We have nothing in European reinsurers as although we think they are sound businesses, they are looking quite expensive.'
Most of the financials exposure is in tier two covered bonds, and the pair prefer UK banks over their European counterparts, with bonds in Barclays and RBS held.
Over three years to the end of December, the fund has returned 37.6% compared to the Merlit iBoxx Sterling Corporates benchmark return of 32.4%