Fund Manager's Viewpoint: Stephen Snowden

Stephen Snowden, manager of the Old Mutual Corporate Bond fund, on a volatile outlook for the months ahead.

Despite the recent sovereign uncertainty and volatility, we would argue that bond funds are still a worthy part of investors’ portfolio as their income generating potential relative to mediocre deposit rates is still firmly in place.

Volatility has returned once more to unsettle markets. Sovereign solvency-induced market pain has been a regular feature since Dubai started the ball rolling six months ago. We expect it to continue to interrupt markets for at least another six months, and probably much longer than that.

The first phase, in Dubai in late 2009, seemed a long way away for UK-based investors; the second phase, in Greece in February, was a little closer to home. The FTSE 100 fell over 8% and credit weakened, but the market quickly brushed its concerns aside. The third phase is PIIGS contagion. In many ways due to the electoral cycle in Germany, the timeliness of the Greek assistance package was lost, allowing the cancer to spread. All the PIIGS were dragged down, UK equities fell 12% and credit experienced a sharp sell-off.

The bazooka finally came out and markets recovered sharply following the announcement of the Eurozone bail-out package. However, although the pending liquidity crisis has been solved for the time being, the problem is still there and investors are rightly very concerned. While the prospect of European sovereign defaults has been in the back of their minds, it has finally presented itself as a tangible reality.

Governments across Europe are finally embracing the problem in a timely manner.  Spain and Portugal have suffered the most as concerns have spread outwards from Greece. But now both Spain and Greece are pushing through a 5% cut on civil servants’ pay, taxes are going up and formal announcements of fiscal adjustment plans are scheduled for mid-May. Even the UK is moving forward, with the new coalition government due to present details of tax hikes and spending cuts in 50 days.

Higher taxes and constrained public sector spending will keep unemployment high, containing consumption and resulting in modest economic growth. Interest rates will therefore have to stay low to keep the blood flowing, meaning that inflation is not a fear in the short to medium term. Commodity prices may rise, but that is not the key driver of inflation. Sterling has already depreciated in recent years, so imported inflation is less of a threat going forward. Low interest rates lead to mediocre deposit rates.

We are not bullish on gilts – there are simply too many of them – but neither should one be fearful. The UK has its own currency, a luxury that the PIIGS do not share.  The UK also has a very long average debt profile, the highest in the industrialised world, so roll-over risk in the UK is very low. The Bank of England has not ruled out further Quantitative Easing. The new government will tackle the budget deficit and a coalition may help, as two parties instead of one will absorb the public anger over the cut backs, easing political damage. Acting quickly will also allow for easily laying the blame at the feet of the outgoing administration. Finally, the UK already has one of the steepest yield curves in the industrialised world – in other words, gilts are already cheap.

The low growth environment is not only good for government bonds; it is also the ideal environment for corporate bonds. If growth is strong, corporate management teams become bolder, increasing leverage to fund acquisitions, dividends and share buybacks, all of which is bad for credit quality. If growth is modest, conservatism rules, which is clearly positive for creditors.

We expect the markets to remain volatile over the coming months. The focus for a period will be on improved economic data, strong company results and a modest level of corporate bond issuance, enabling corporate bonds to rally. Markets will then be reminded of the enormity of Western budget deficits, at which point corporate bonds will experience a renewed sell-off.

Investors seeking a good level of income, over and above that available from deposit rates, will have to accept some investment risk. But volatility presents nimble fund managers with opportunities to capitalise on market moves.