UK bond fund manager Richard Woolnough is taking a combination of measures to lessen the sensitivity of the M&G Optimal Income Fund to the risk of yield rises. But others warn that reducing duration on a bond portfolio could leave investors exposed to equity markets.
Regarded as one of the UK's leading bond fund managers, Mr Woolnough has reduced the portfolio duration of the fund largely through the sale of government bond futures to just 3.3 years in expectation that yields on short-dated government bonds will rise.
The portfolio's duration of 3.3 years compares with a neutral position of 5.4 years and a duration position of 5.0 years at the end of 2010.
Most of the M&G Optimal Income Fund's duration exposure is focused on the UK. Mr Woolnough expects the UK economy to remain weak in 2011, with a stagnant housing market, high unemployment and fiscal austerity weighing on growth. In this environment he believes the Bank of England will tolerate the current high level of inflation and keep rates accommodative in order to prevent further economic weakness.
Last month Fidelity International warned that investors nervous about the impact of rising interest rates on government bonds should be wary of strategies such as lowering duration and/or increasing credit risk.
Richard Woolnough
Ian Spreadbury, manager of Fidelity's Strategic Bond Fund, said: "In my view, the key to building a diversified bond portfolio, which has a low correlation with equities, is to retain some combination of offsetting duration risk and credit risk. Since the two are generally negatively correlated, this balanced approach helps to smooth the overall return profile of the portfolio over time, while retaining some of the defensive characteristics traditionally associated with an investment in bonds."
Mr Spreadbury moved to protect the Fidelity Strategic Bond Fund against inflation by mechanically varying the asset allocation of the fund, giving up government bonds in preference to investment grade and high-yield corporate bonds and inflation-linked bonds. In the latter area, he favours UK, US and Japanese issues.
Mr Woolnough has also added index-linked gilts to the Optimal Income Fund with these now accounting for 6.3 per cent of the fund, held mainly in the 2017 issue that pays 1.25 per cent above inflation. The price of the issue implies that retail prices inflation will average 2.9 per cent over the next six years - he believes that the 2017 index-linked gilt represents good value relative to conventional gilts and cash.
The M&G Optimal Income fund was tipped by Investors Chronicle in April 2010 and remains on our buy list.
