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By Holly Cook| 4-1-2014 3:00 AM

3 Bond Investing Tips

Rising interest rates, quantitative easing from Japan and implicit market support from the European Central Bank all make for interesting opportunities for bond investors

Holly Cook: For Morningstar, I'm Holly Cook. Today, we are looking at 3 Stock Tips, our regular feature, but we're changing it up a bit for you today and actually looking at the bond sectors. Joining me is Dickie Hodges. He is Manager of L&G Dynamic Bond Trust, which is rated Silver by Morningstar’s analysts. Dickie, thanks for joining me.

Dickie Hodges: Thank you for inviting me.

Cook: So, normally, we look at stock tips here, but of course, with you here in the studio we’re going to be looking at the bond investing environment. So what would be the sector that would be one of your favourites at the moment?

Hodges: I think its conventional wisdom in an environment, where we've got interest rates lower for longer, the demand which we still got for an income level of between 5% and 7% that would dictate one of the areas which you need to look at is obviously a high yield bond market. Clearly, the economy is improving gradually. Signs of some sort of recovery, but we are still in this – which is a very good area to be with regard to high yield, moderate growth. So, if you’re looking still for return of around 6%, then clearly that is one of the few areas left in the world’s bond markets that can actually deliver that return with, I would argue, an acceptable level of risk.

Cook: So you mentioned there, risk. I mean what is the main risk with the high yield sector?

Hodges: I think the main risk of the high yield sector is the fact that it's becoming increasingly more expensive. Over the course of the last three years, we’ve seen a compression of spreads, i.e., the yield available on high yield has been getting lower and lower as the demand has been increasing for the asset class. At some stage if we move into environment where we are going to see interest rates rising, I would argue that the high yield sector will be much more sensitive to those changes in interest rates. Now, that will still give a negative return on prices of high-yield assets. So I think the real key thing, which we have to get it right is the timing of when interest rates rise either in the US or indeed the UK.

Cook: Okay. So what would be your second favourite bond sector?

Hodges: Again, it's all to do with the demand for assets and the demand for level of income. And, again, it's looking to see where you can generate those returns from. Conventional wisdom would still dictate that you would have to look at more subordinated levels of financial debt. Many people would argue that what is what we class as a core Tier 1 capital ratio has improved the dynamics and the possibility of future defaults is diminished from the banking sector, and this is Europe wide, plus with the support from – the implicit support from the Europe Central Bank. This would lead normally to an environment where subordinated levels of financial debt will actually give the performance that you require. But let's not forget that, again, this is still a very risky proposition and these are very high beta assets. Now if you're owing an asset that yields 7% compared to a government yield of roundabout 2%, then clearly there is implicitly enough risk in that asset class. So you have to be very careful about where you're investing and which country you're investing in as well.

Cook: So would the general risk that applies to the eurozone as a whole, be the main risk for that [bond] area?

Hodges: Very much so, yes. I mean it's also the ECB. I think a lot of people are factoring in the basis that there is going to be some support from the European Central Bank in some shape or form along the lines of quantitative easing that we're seeing both in the US and in UK, and obviously the quantitative easing that the Bank of Japan are undertaking as we speak. So I think the environment which we're moving dictates that you do have to have these assets to get the returns. But, again, you have to be very careful about where you're looking to invest.

Cook: So we're running out of sectors. What's going to be your third bond sector tip?

Hodges: Again, this is primarily driven by the implicit support from the European Central Bank and certainly, from my perspective, you've got to look at periphery European debt. And I know it sounds quite strange and it sounds very risky indeed, but one of the best performing bond markets year-to-date, globally who has been that at the Portuguese government bond market, you've seen five-year government bond yield start from the December 31 around about 5.5%. Today, they run about 3 to 3.5%. You've had a significant drop in that yield, which – obviously that corresponds to rallying in prices. So you've seen great performance out of this asset class, but let's put it into context. They are still yielding around about 3%, when five-year German government bond market is yielding roundabout 1% or 0.5%.

Cook: So if you want that extra yield, you've got to take on that extra...

Hodges: You've got to take that risk as well in a very few areas. Even in the corporate bond market, a cutback can deliver that sort of yield certainly throughout Europe. So I know it sounds, again, a proposition that might have scared people in – 18 months ago. But the fact of the matter is, if you're looking to generate a level of capital return and income, you're almost forced to move into these asset classes that have proved cheap.

Cook: Just thank you very much for joining me today and giving us your bond sector tips.

Hodges: Yes, No problem. Thank you.

Cook: For Morningstar, I'm Holly Cook. Thanks for watching. 

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