A very real threat of a UK downgrade has not been priced into credit markets, meaning funds with a large exposure to Government bonds could soon be left out of pocket.

This is according to FE Alpha Manager Ian Spreadbury (pictured), who says that despite the renewed optimism around the UK economy in recent weeks, there is a general deterioration of credit quality in the markets, in both the private and public sectors.

The manager of the £1.13bn Fidelity Strategic Bond fund is negative on government bonds in general, believing that investors are ignoring the disastrous debt levels that threaten their credit-worthiness. 

"I do not think the markets are pricing in the deteriorating credit quality of the UK sovereign," he said.

"I think its credit rating could come under pressure and that has not been factored in to the markets." 

"What we have seen globally is the shifting of debt from the private sector onto the public sector, but no resolution to the issue." 

"Until the fundamental problems of high indebtedness are solved, we will be in the same high-tail risk environment and I think there is still the risk of another crisis, albeit further down the line." 

Spreadbury currently prefers to be overweight his benchmark on investment grade corporates, as he thinks they will only become more attractive to income-seeking investors. 

"What are you getting paid for when you buy a bond? It is default risk, liquidity risk and volatility risk."

"My theory is that in an environment when investors are chasing yield, so are being forced into riskier areas, they will be prepared to accept a lower premium for liquidity and volatility than has been the case."

"The default risk in investment grade corporates is only 20 basis points per annum, so you are getting paid quite well historically." 

Recent issues from National Grid, Housing Finance Corp and BAA have all been at levels attractive to gilts, Spreadbury says, adding that the poor macro environment makes choosing the right bond essential. 

"The slow-growth environment is hitting credit quality, so from a selection perspective you need to be careful. Default risks are picking up, as they always do when growth is under 1 per cent, and we expect this to continue."

Spreadbury also thinks the negative effects of recent rounds of quantitative easing have not been appreciated.

He commented: "QE is keeping nominal growth up but not real growth. I do expect more QE and more aggressive forms, which will continue to support asset prices."

"With more QE will come the risk of more inflation and that’s not factored into the markets." 

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Data from FE Analytics shows that the £1.13bn Fidelity Strategic Bond fund is a top-quartile performer over five years, returning 52.82 per cent as against the IMA Strategic Bond sector’s 28.8 per cent. 

Performance of fund vs sector and index over 5-yrs



Source: FE Analytics

Its current yield of 2.83 per cent puts it in the bottom quartile in its sector, although it is one of the more cautious portfolios: a five-year annualised volatility of 5.88 per cent means it is among the 10 least-volatile strategic bond funds. 

The fund has a minimum investment of £1,000 and a total expense ratio of 1.21 per cent.