The Analyst: Bonds are our new flexible friends

The idea that bonds are always a safe investment is woolly-headed at best; they can be as volatile as shares. I remember that, in 1994, government bonds lost about 20 per cent when the Federal Reserve started to push interest rates up from all-time lows.

However, there is also no doubt that they can be a superb investment when used in the right way at the right time. Many people are now positive about the medium-term prospects for bonds, and some of the yields look very appealing.

There has been a plethora of new bond-fund launches in the past few years. An environment of low inflation, coupled with an increasing number of bonds available to investors, has led to many more opportunities. However, one key problem remains for private investors: what kind of bond to buy?

The range of options is dizzying and the terminology is arcane. Do you opt for investment-grade bonds, high-yield, or gilts? What are the spreads? Do you select long-dated or short-dated bonds?

Each one of these asset classes will tend to perform differently in various economic scenarios. For example, a large holding in high-yield bonds will be extremely beneficial at one moment and potentially disastrous at another.

One way around this problem is to invest in a fund where an expert manager can make the asset allocation decisions for you.

One such fund that I find interesting is the Henderson Strategic Bond Fund run by John Pattullo and Jenna Barnard. Mr Pattullo first joined Henderson in 1997 as a credit analyst on the Preference & Bond Fund, which he now also runs. Ms Barnard has worked with Mr Pattullo since 2002, and became co-manager of the Preference & Bond Fund in 2006.

The basic philosophy behind the Strategic Bond Fund is to provide flexible access to all types of bonds. This means the managers are not tied to a benchmark and, importantly, there is no income requirement. Returns can therefore be driven from a combination of capital and income rather than the fund managers having to buy a bond just for the income.

This will result in a fluctuating income over the time, but it does mean that the managers' focus is on achieving the best total return rather than, as I have seen with some bond managers, destroying capital for the sake of a higher income.

Mr Pattullo is also able to use derivatives in order to "go short"; in other words, to profit from falling prices. Bond managers, in fact, have been using derivatives for many years and have more experience of these complex instruments than the average equity manager. The only similar equity fund that I can find at present is BlackRock UK Absolute Alpha, which I have already highlighted in previous columns.

The use of derivatives allows the fund managers more opportunity to show their skills. They can profit from market areas that they believe will go down in price rather than merely looking for things to rise.

At present, the fund is 80 per cent invested and 20 per cent in cash, but both fund managers see compelling valuations, especially in the bonds of financial companies. The problem at the moment is that although there are many promising opportunities, the momentum is dreadful. There are so many forced sellers in the market that prices are being pushed down. They have already reached the level where implied default rates for financials are at 20 per cent. This is an astonishing figure and, if true, it suggests that one in five UK banks will go bust in the next five years. If you don't believe that will happen, then these bonds must be fantastic value.

The managers are being canny, though, and are drip-feeding cash into the markets. They are doing this because it is impossible to know when the bottom of the market will be and they are averaging out their entry price by investing at intervals.

Since Mr Pattullo took over the Henderson Strategic Bond Fund, its total performance has been roughly in line with its sector average. It is worth remembering, however, that the UK Other Bond sector it resides in is home to funds with very different remits. Some of them are also able to invest a certain amount in shares, which gives them very different characteristics.

The present yield on the Henderson Strategic Bond Fund is 7.4 per cent, which looks extremely attractive. This could be an excellent opportunity, and not just to pick up a very good yield; with interest rates falling, there is a chance to make capital gains as well.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent