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Gilt fund spots huge low risk opportunity

Created:

19 February 2009

Written by:

Moira O'Neill

BULL POINTS:

■ Potential higher reward than corporate bonds

■ Low risk protection from inflation

■ Experienced manager

BEAR POINTS:

■ Short track record on fund

■ Prolonged deflation could damage returns

Recent blanket coverage of corporate bonds concludes they have become so cheap as to represent a smart asset class for allocation. But Ian Williams, manager of the City Financial Strategic Gilt fund, disagrees, seeing weaker global growth, declining revenues and deflation as a recipe for corporate debt default on a massive scale.

He says: "Although corporate bonds seem to be garnering a lot of attention, it is index-linked gilts that could be the consensus play of 2009. These gilts offer protection from inflation while having the distinct attraction of being, at the moment, very cheap. So cheap in fact that as Bill Gross, the Co-Chief Investment Officer of Pimco and manager of the largest bond fund in the world, pointed out in a note to clients on 8 January 2009, the prices of index linked US treasury bonds could sustain deflation of 1 per cent a year for ten years and still break even.

"Short-dated index linked gilts offer a potential higher reward than corporate bonds with a much lower level of risk."

Mr Williams is worth listening to because he has 25 years experience in the bond markets, including head of bond options at Dresdner Kleinwort Benson and director in charge of all Government bond trading at Guinness Mahon.

While his City Financial Strategic Gilt fund itself has a short track record - just two years, it came top of the IMA UK Gilts sector in 2007 by investing solely in AAA UK Government Bonds, returning 6.47 per cent, compared to the IMA Gilt sectors average return of 2.83 per cent over the same time, and has attracted the attention of independent financial advisers AWD Chase De Vere Wealth Management.

Jason Walker, senior manager at AWD Chase De Vere Wealth Management, explains: "Index linked gilts offer a great opportunity for clients concerned about inflation, particularly retirees who depend on investment income to top up their pension." Although inflation may not seem like a concern in the short term Mr Walker thinks the effects of aggressive reflationary measures by governments worldwide will only serve to increase upward pressure on general price levels and with a large amount of corporate and government debt in the economy, inflation may be welcomed by policymakers. This in turn will benefit holders of index linked gilts which could look cheap if inflation significantly increases.

So couldn't investors just buy gilts direct? Mr Walker thinks not: "I would recommend a collective holding in gilts rather than buying single holdings as the investor will benefit from someone who truly understands the gilt market and can take advantage of the opportunities in different market conditions."

The IFAs think City Financial Strategic Gilt fits the bill because Mr Williams has "consistently shown a good understanding of the macroeconomic environment and truly actively manages the fund - not just within conventional gilts but into cash and index-linked gilts too".

"This in itself is very unusual," says Mr Walker, "but, at the appropriate time, he can also write options to enhance the returns."

The fund invests only in UK gilts. There is no corporate exposure of any kind. It aims to offer a superior risk-adjusted return over that of passively holding a conventional gilt portfolio with similar risk characteristics. It has the ability to write options on the underlying portfolio, with the aim of enhancing the total risk-adjusted return of the portfolio and reducing volatility.

Mr Williams had a particularly strong December, returning approximately 6 per cent, largely attributed to a substantial position in index-linked gilts purchased in November.

Key fund data:

Source: Investors Chronicle funds data and City Financial, * Morningstar