Balancing the bond business

By Keiron Root

10 May 2000

Perpetual is a fund management house that has built its reputation on the long-term performance of its equity funds, but the group also has an active fixed-interest department headed by Paul Causer.

Mr Causer's entry into fund management was a logical continuation of his academic career. "I did an economics degree at the London School of Economics and, being just down the road from the City, it was a natural place for me to look for a career."

He took his new economics skills to the Japanese commercial investment house Asahi Bank and was introduced to the world of fixed-interest investments. "I got involved in the Treasury function, which meant covering areas such as fixed interest, bond markets, foreign exchange and so on. I ended up managing the bank's portfolio before moving to Perpetual in May 1994, to do what I like to call 'real fund management'." What makes his role at Perpetual "real" is the fact that he is managing money for outside investors, rather than in his previous role where investment was purely on the bank's own account.

Mr Causer now jointly heads the group's fixed interest team with another experienced bond manager, Paul Read. With colleague Michael Matthews, they are responsible for the management of one of Perpetual's newer unit trusts, the Perpetual Monthly Income Plus Fund.

The structure of the fund is unusual in that it is a high-income vehicle that holds a mixture of high-yielding bonds and equities. "The fund was launched in February 1999 and partly came about from input from the rest of the fund management team," says Mr Causer. "Income products were the popular thing at the time and, as a house, we had already been involved in the new high- yield fixed-income market in Europe and also had a successful equity income fund.

"So we asked ourselves what we could offer the investment market that was different and came up with the idea of a fund with a bond and equity split."

The bulk of the fund is always invested in bonds to secure a high level of income, which is why Mr Causer's fixed interest team oversees its management. "The maximum equity element is 20 per cent, but we believe that where we can add value is in managing the split between equities and bonds to best effect."

Perpetual places great stress on the importance of actively managing portfolios throughout its unit trust range, and its Monthly Income Plus Fund is no exception. "The actual equity element has varied between 15 and 18 per cent over the life of the fund. At present it is around 18 per cent. The bond portfolio is what we would term 'high yield' which means many of its bonds are below investment grade, below a BBB rating."

The rating system an indication of the level of security within a bond. The fund is investing in bonds issued by companies (corporate bonds) which carry a higher level of risk rather than government issues, such as UK gilts. These bonds are rated by independent rating agencies (of which the best known are Standard & Poor's and Moody's), with AAA being the highest rated, or most secure. The ranking continues through AA and A grades to BBB, BB, B and so on.

Investment practice, particularly among institutions, is to limit their bond holdings to the most secure "investment grade" bonds, those rated BBB or above. But because these bonds are deemed the least at risk from default, their yields tend to be lower than those down the rating scale.

"The bulk of our investments are in BB and B grade bonds, but more than 10 per cent of the fund is in investment grade. The equity element will act as a constraint on achieving our target yield of around 8.5 per cent, which is why we invest mainly in high-yield bonds."

The fund is currently yielding about 8.8 per cent. The downside of this is that capital performance is limited, although it has risen by around 10 per cent since launch. "The reason for putting the equity element in was to give the fund a growth dynamic over time," says Mr Causer.

"This is important because we take our management fees from capital rather than income. The equity part of the portfolio has not been in technology stocks and the 'old economy' stocks have been suffering, and they are seriously undervalued.

"Blue Circle, Associated British Ports and Sun Life, which are in our portfolio, have all had recent takeover bids and we expect a lot of these sort of situations. And we have a selection of good solid names which are paying large dividends and providing good dividend growth. European industrial names have performed well this year.

"The phone, media and cable sectors have seen most bond issuance although at present, investing is more about picking the right bond than the right sector.

"The idea is that investors can come into this trust knowing at any time in its life cycle it will be a high-yield fund. What we are trying to do is to actively manage the fund within well-defined parameters, but that still leaves us with a lot of scope to get it very right, or very wrong. Investing in the high- yield market is about picking the right bond, which means that much of what we do is based around credit analysis."

Outside North America, the high-yield corporate bond market is in its relative infancy. This means the fund's bond portfolio has an international flavour. "It is a new market for most people and it will take five to 10 years before investors really understand how it works.

"The trust was launched as a PEP fund and is still managed to be PEP-qualifying, so at least 50 per cent has to be in the UK and EU markets, although the equity element helps considerably in meeting that requirement. Our main focus is on the emerging European high-yield bond market, which is growing at an exponential rate." That area, Mr Causer believes, will be one to watch.