Gartmore Investment Management's European corporate bond fund is making an out-of-benchmark bet on government bonds. "We want to take advantage of the spread compression between 10- and 30-year bonds by buying the long end of the curve and there just aren't enough long-dated corporates out there," said Richard Hodges, manager of the £70 million fund in London.
"Spreads between 10s and 30s are currently around 58 basis points and we see them narrowing to closer to 20bps," said Hodges. He plans to keep the trade on for the whole of 2005 as the long end of the market continues to benefit from inflows from pension funds intent on matching assets to liabilities.
Since only 1% of corporate debt has a maturity of 30 years, the fund manager is forced to turn to the government market to achieve his desired 5% overweight in 30-year bonds. To compensate, he is underweight the seven- to 10-year portion of the curve.
Hodges plans to start using credit default swaps in the corporate bond fund, in response to the tight spread environment and limited opportunity for capital appreciation, enabling him to take larger bets on a name-specific basis. "At the moment we're limited to going short a name by the amount of its weighting in the index; by buying protection we'll be able to increase these positions according to our conviction," said Hodges, who stressed that the fund would not go to an overall leveraged position.
In the corporate space, Hodges is focusing on a limited number of names. He has significant overweights in tier-one bank debt and subordinated insurer debt, and is keen on tobacco names including Philip Morris, British American Tobacco and Gallaher. Conversely, he considers the utilities sector very expensive and sees potential for take-out activity in that space. He is also steering clear of senior bank debt.
The fund has a 85:15 split between investment grade and high yield. While Hodges doesn't plan to reduce the high-yield portion, he is moving money to fallen angels likely to return to investment grade by 2006, such as Alcatel and Ericsson. "Any rise in interest rates will be punitive for lower quality bonds, and these names are already trading on the spread over government debt, not on a price basis like typical high-yield names," pointed out Hodges.
