Fidelity's sterling bond fund celebrates three year anniversary

Corporate bonds should bounce back in 2008, after a year of significant underperformance, but a flexible approach will be needed to continue providing investors with a consistent income. As the top quartile FIF Sterling Bond Fund reaches its third anniversary, Portfolio Manager Ian Spreadbury believes that while the economy will deteriorate further, corporate bonds are on the way up.

He comments, "Gilts beat corporate bonds hands down in 2007 and in the first quarter of 2008 as the credit crunch hit hard, so the fund was positioned defensively, which benefited returns - but this is a new world of fixed income and I expect investment grade corporate bonds to turn the tables in the medium term, which is reflected in my asset allocation. This will come against a backdrop of a worsening economy. We are already seeing tighter lending standards and this is likely to spill-over to household consumption, the housing sector and business investment. Bank of England interest rate cuts have not yet made financial conditions demonstrably easier - the cost of borrowing is high and the capacity of banks to lend has eroded.

"In over two decades of fund management, I have never seen sterling corporate bonds offering such reasonable value - now is the time to increase exposure. While UK government bonds will continue to perform well, we are seeing a remarkable situation in corporate bonds - yields normally hover around an economy's nominal growth rate but at the moment are 7%, compared to nominal GDP forecasts of under 5% out to 2009. Credit spreads may widen further in the near term though, so balancing gilts and bonds effectively will be the key to consistent returns."

Mr Spreadbury highlights four areas that could give bond investors the possibility of out performance in 2008: asset backed securities (ABS), interest rate positioning, financials and out of benchmark positions. He continues, "ABS as an asset class has suffered indiscriminate widening of spreads, with even the highest quality names weakening. I'm broadly neutral in ABS at the moment, as liquidity issues continue, though some of the best buys in the market are emerging in this space. For example, prime UK and European residential mortgage backed securities are offering very attractive yields that already discount a significant rise in mortgage defaults. Unlike subprime lending in the US, UK and European mortgages are of a much higher quality but are priced for the absolute worst.

"Interest rate positioning is key to a flexible fund like Sterling Bond Fund. I have a UK curve steepening position given my expectation that short-dated interest rates should fall more than longer-dated rates as the Bank of England cuts interest rates further.

"Bonds issued by banks and financials, traditionally very dominant players in the fixed income world, were hit particularly hard in 2007. We have remained underweight financials for some time and it is too early to say when they will return to form. However spreads do offer good value at these levels and I have recently started increasing my weighting."

Mr Spreadbury concludes that out of benchmark positions have been playing an important role as additional sources of diversified returns, "I look at ideas on a global basis, which gives me the opportunity to add assets such as New Zealand and Australian government bonds, whose economies are doing well but could slow down, which in turn should lead to cuts in interest rates. As well as some high yield and emerging markets bonds I have found some excellent bonds in the energy sector which are non-rated and therefore under-researched by the investment community. The combination of these strategies enables me to offer a more consistent return profile, with no single strategy swamping returns of the fund."

The £134m FIF Sterling Bond Fund was launched on 18 April 2005. It is one of the most flexible bond funds available and can allocate 100% to corporate bonds, or up to 90% government bonds and up to 20% in high yield debt, according to prevailing market conditions. Mr Spreadbury, who has 23 years' investment experience, benefits from Fidelity's multi strategy approach to fixed income investing - where credit research, quantitative analysis and specialist traders combine to offer a range of investment ideas for inclusion in a portfolio.