Mark Dampier: Strategic bond funds may ease conundrum

A few weeks ago the merest hint from Ben Bernanke, chairman of the US Federal Reserve, that the US might begin to slow its quantitative easing (QE) programmes sparked a bout of selling across financial markets.

He didn't reveal anything we didn't already know, but after a strong run it wasn't going to take too much to unsettle investors and encourage some profit taking.

The recent sell-off has brought a key problem for private investors back to the fore. The last thing the Government wants us to do is hold a significant proportion of our wealth in cash. They would prefer savings to either be invested or spent. This should help prop up financial markets and boost economic growth, or so the theory goes. By holding interest rates artificially low and allowing inflation to remain above the 2 per cent target this is exactly what many are forced to do.

Lower interest rates also allow the Government to borrow cheaply and reduce interest payments on existing debt. While inflation remains above interest rates this is also eroding the value of total debt in real terms. In financial jargon this is referred to as "financial repression".

Bond investors in particular face a conundrum. A yield in excess of 4 per cent on corporate bonds might look attractive, but it comes with the risk of capital loss. With interest rates unlikely to rise until after the next general election in my view, this situation could persist for a while longer. The trouble is when interest rates do eventually rise, bond yields will look less attractive, investors will demand a higher premium for the additional risk and prices will fall. No one knows exactly when the point of no return will be reached, but it is getting closer.

For investors looking to maintain exposure to fixed-interest I believe strategic bond funds are worth considering. These have the flexibility to invest across the fixed-interest spectrum, from traditional government and corporate bonds to higher-risk, high-yield bonds that behave more like shares. They also provide the fund manager the freedom to invest overseas, potentially benefiting from currency movements, and to take evasive action against any sell off in bond markets, by positioning the fund to benefit from rising yields (and falling prices), for example.

There is a caveat though. With flexible funds such as these the return depends far more on the manager's ability to make the right decisions at the right time – an extremely difficult task. One fund manager I have considerable faith in is Ariel Bezalel. He launched the Jupiter Strategic Bond Fund in June 2008. With hindsight the timing proved opportune.

After five years the fund has comfortably outperformed its sector. Mr Bezalel has used the full flexibility of the fund to add value in a variety of market conditions. Investments in the financial sector during 2009 and 2010 highlighted his ability to successfully time the market and achieve attractive returns, although there are no guarantees he will repeat this.

Looking ahead he suggests the US and European economies face contrasting fortunes. The US seems to be experiencing a sustainable recovery while Europe is struggling to produce any growth. The UK seems to be somewhere in the middle. If the US recovery continues it could lead to higher yields (and lower prices) on corporate and high-yield bonds. At some stage the Federal Reserve could be the first major bank to increase interest rates. He is therefore avoiding US corporate bonds and has a "short" position on US government bonds, meaning the fund could benefit if yields rise (and prices fall). He is happy to hold a portion of the portfolio in US dollars believing the currency could strengthen, but this hasn't worked recently. Further diversification is achieved through positions in Australian government bonds and holdings in defensive, high-yielding investment grade debt.

At least in part the answer to the bond conundrum is to move away from pure, investment-grade corporate bond funds into more strategic funds such as this. These more flexible funds could at least preserve some capital or even make some money in a more-challenging environment for bonds.

This could provide a middle ground between the additional volatility of equities and poor returns available on cash deposit.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial advisor and stockbroker. For more details about the funds included in this column, visit hl.co.uk/independent