Fund manager keeps positive outlook on credit markets

Valletta Fund Management Limited launched the La Valette Sterling Income Fund in April 2002 to achieve a high level of income. The fund is managed by Insight Investment Management (Global) Limited of the largest UK-based portfolio managers with assets under management of £116.6 billion, of which fixed income and money market assets account for just over 80 per cent (or £93.8 billion, as at March 31).

We have used recent market strength to reduce holdings where liquidity had been problematic, while taking advantage of attractively priced new issues. Our policy has been to favour long-dated bonds over medium-term debt as we believe there is more demand at the long end.

The fund has held a long-term preference for bonds issued by financial companies. In particular, we favour bonds issued by banks which are at or near the top of their capital structure. The banks we have chosen have received substantial support from their governments, and thus the securities offer very attractive yields, despite being in a position where they will not be allowed to fail.

This exposure has benefited the fund significantly in recent months as financial bonds have risen the most compared to other sector.

We are forecasting economic growth to remain sub-trend in Europe and the US for the next year. Given this environment, we expect inflation to remain subdued and interest rates will not need to rise. Although economies will remain sluggish, the rate of decline will slow and there will of course be some moments of temporary optimism.

The recent improvement in the corporate bond market has meant that we have reduced our forecast for defaults. Therefore, we remain positive on corporate bonds on a strategic basis. The market has room to rally further now that the systemic risks have been curtailed. However, on a tactical basis we are now expecting to see a period of consolidation. We would expect the market to ultimately trade sideways, as opposed to return to pre-credit crunch levels. We expect the elevated level of new issuance to continue as corporates move from relying on bank finance to capital market financing.

In the second half of 2008, corporate bond markets were badly affected by the unfolding financial crisis. There were severe concerns about the health of the banking sector in particular, with governments in Europe and the US forced to step in to stop banks from failing. As a result, not only did corporate bond prices fall, but liquidity drained from the market, making it all but impossible to buy or sell most bonds. During this period, investors flocked to the perceived safety of government bonds, even after government support for the sector meant that many financial bonds effectively became government debt.

Eventually, markets became more confident about the outlook for the global economy. Signs of improved economic data and corporate earnings meant that markets regained their 'risk appetite' and from April 2009 began to move out of safer assets such as government bonds and into cheaper and higher yielding assets such as corporate bonds (Chart 2). Bond prices did not necessarily move back to pre-crisis levels, but moved from pricing in a 'Great Depression' scenario, to pricing in a hard recession.

The primary beneficiaries of this recent return of risk appetite have been financial bonds. Banks have also been very keen to buy back some of their lower-rated bonds. These were trading at very cheap prices, and banks were therefore eager to exploit this.

This helped to return some liquidity to markets and boost sentiment, meaning that the financials sector become the best-performing sector of the second quarter. In addition, earnings results from financial issuers showed that many of them returned to profit after multiple quarters of losses.

Some of the opinions expressed are of a forward-looking nature and should not be interpreted as investment advice. Valletta Fund Management Limited, Bank of Valletta's Fund Management subsidiary, is a joint venture between BoV and Insight Investment.

Mr Bentley is fund manager of the La Valette Sterling Income Fund for Insight Investment Management (Global) Limited.