The collapse of the euro remains one of the key risks to investors in 2012. For Richard Woolnough, M&G's star bond fund manager, the crisis brings with it new implications for bond investors asking the question: What is risk-free?
Although investors are being paid well to take credit risk, Mr Woolnough says they need to be very careful about who they lend to and where they lend, with peripheral sovereign states and financials topping his worry list.
The traditional view is that the risk spectrum starts with cash (low risk) and moves onto government bonds, corporate bonds and equity, but Mr Woolnough believes this basis is "severely challenged". "The traditional view is that corporate bonds are risky and government bonds are risk-free. But Greece is on the verge of default and there are problems in the sovereign credit markets, while investment-grade corporate credit is less risky than five years ago," he says.
"The corporate sector is in better health than the government sector. There is a good cohort of government bonds out there. But governments aren't risk-free anymore. Even the UK might not be AAA in future."
Although corporate bond spreads are very wide, Mr Woolnough says corporates are in good shape fundamentally, have limited refinancing needs, with the market remaining open for new issues. "You are being paid very well for taking credit risk," he says. "We own a lot more credit risk than we used to – with over 10 per cent in high yield. At the moment, you can take lots of defaults and still be better off holding corporate bonds."
There are legal implications too for bond investors: "The ability to pay and the willingness to pay back can be quite different," says Mr Woolnough. "With a sovereign state the ability to pay may be there but willingness is a different matter. With a corporate you have legal rights and there is recovery.
"Legal recovery in sovereign states is very difficult. How could you enforce against Greece? You can't invade and wouldn't want to do anything nasty. It would be difficult dealing with that situation.
"The US has been downgraded not because of its ability to pay but because of willingness – the willingness to pay is political."
But he still thinks that US debt is attractive versus UK gilts as quantitative easing is not fully priced into US debt – he has put this theme into his M&G bond fund portfolios.
Richard Woolnough – CV Richard Woolnough joined M&G in February 2004 from Old Mutual. He had been manager of the M&G Corporate Bond Fund since February 2004 and manager of the M&G Strategic Corporate Bond Fund since launch in February 2004. He launched the M&G Optimal Income Fund in December 2006. He has 26 years of experience in fixed-income markets. |
Returning to the eurozone problems, Mr Woolnough likes to find corporates that are tarred with the same brush as member states but are in better shape. "We also have to think about how much of a company's business is pure European. Many 'European' companies are not doing much of their business in Europe. So while we don't hold Greek banks we might own a Greek corporate."
Portugal Telecom and Telefonica are Mr Woolnough's examples of companies in good shape that are unfairly tarnished by their home countries, Portugal and Spain.
Financials on the other hand are a completely different matter. "Corporates given BB ratings can still survive because they have something people want. But banks lose trust from low ratings so people don't want to use them. A bit of bad news puts banks nearer the cliff edge."
Although Mr Woolnough says the banking system will survive, investors need to treat them as high-yield, high-risk assets.
"Even though we do buy banks we have remained underweight," he says. "We have a secular bear market in banking. Within that some banks will do well and some poorly. But remember that all a bank does for you is security (bank account, deposit box, etc) and software (which you can get better elsewhere). That is not a great business model and is why they do other things with your money – think of it as recycling your money."
All of these risk issues underpin his method of investing in bonds. "Equity investors are more bullish – they just have to get one stock right to do well. But if I get one bond wrong I can lose a lot. So our job is to avoid the losers rather than find the winners."
This is where he sees potential problems around retail issues of bonds. "As bond investors we have to understand our legal rights. It is very important to us to know what recovery we can get. However, each bond can have a different legal document attached to it. Even we can have difficulty understanding that. A man in the street won't know the exact legal issue. That is what worries me."
He is always looking for cheap equity ideas for his M&G Optimal Income fund and is very positive about equities at the moment. In this fund he owns highly rated, blue-chip oil and gas companies (Shell and BP), pharmaceuticals (AstraZeneca) and technology in the US (Microsoft and Apple). "Eventually over time Apple will become a boring stable company and will start paying dividends," he says. "Are your legal rights as an Apple shareholder stronger than those of a Greek or Italian bond holder? Yes."
