Barry O'Neill: Spreading credit can give corporate gilts an extra edge

INVESTORS have traditionally flocked to gilts as a safe haven in times of economic uncertainty. But what happens when the safe haven proves not to be quite so safe? There are genuine concerns about the outlook for gilts this year, leading to some investors accepting the higher risks associated with corporate bonds in order to secure the extra return over gilts, known as the credit spread.

The problem is that when purchasing a corporate bond, a significant part of the overall return is still driven by the yield from gilts. In recognition of this, SWIP launched the Sterling Credit Advantage fund in September 2008. Fund manager Luke Hickmore explained: "We're just trying to capture the return from corporate bonds, while removing the volatility associated with gilts. If you bought a Marks & Spencer corporate bond paying 5.5 per cent, 3.5 per cent of this yield is effectively driven by the gilt yield, with the extra 2 per cent being the corporate risk, ie the bit that we want. We achieve this by selling the gilt part of the return to someone else."

The fund has a wide-ranging mandate and can buy euro and US dollar bonds as well as GBP issues. Any currency positions are hedged back to sterling to remove this potential additional risk. "The UK market is dominated by a small number of players, of which we are one of the largest. This can lead to some liquidity issues here, but in Europe there is greater depth and thus better liquidity," said Hickmore.

He believes the current environment is set fair for the fund to perform solidly. "The fund will do well if corporate balance sheets are strong and if Libor (the London Interbank Offered Rate] goes up."

The fund is structured to enable the manager to use derivatives to remove any unwanted risks. This facility was put to good use in January, when Hickmore purchased a derivative that protected the fund from a potential loss of capital due to a widening of credit spreads.

The fund has a relatively modest target to return 0.75 per cent more than the Bank of England rate before fees and tax. At the moment, this would clearly be unattractive. Fortunately, the fund outperformed its benchmark significantly in 2009, with an 11.5 per cent return.

Hickmore added: "Positive total return funds are playing an increasingly important part in wealth management portfolios and for fund of funds managers. They are what people want."

For more information on the SWIP Sterling Credit Advantage fund, call 0131 655 8500 or visit www.swip.com.

• Barry O'Neill is a chartered financial planner with Thomson Shepherd Limited (incorporating Coggans Wood).