With the rate of interest from cash and traditional fixed income securities so low, bond investors have had to look higher up the risk curve for a decent level of income.
Johnson and Harris favour the contingent convertible [Coco] bonds issued by the likes of Lloyds and Barclays, which offer a coupon of around 7 per cent.
Many investors think these bonds are too risky, as they will be exposed to losses if the banks perform very poorly.
However Johnson, manager of the Old Mutual Corporate Bond and the Old Mutual Monthly Income Bond funds, says banks have had to go through an extended period of deleveraging and regulations require them to keep capital ratios high, which means these Coco bonds are far safer than the market appreciates.
Johnson says this has not always been the case and that she used to steer well clear of this type of unsecured debt.
"In the past, I have actually described them as a reverse lottery," she said.
"Someone comes and gives you £2 a week and then one day they say you owe them £20m. I say this because although they look and feel like an ordinary bond as they pay a coupon, when a pre-described trigger is hit, that coupon is suddenly written down to zero."
"When that happens you can lose everything, or in some cases you get converted into equity at a very unfavourable rate," she added.
Johnson says that these "trigger" points rely heavily on the capital strength of the bank and if that level were to drop, this type of bond would effectively become worthless.
Coco bonds are tier-one credit, meaning they offer the highest reward on the capital structure but at the same time offer little in the way of protection.
That has caused many investors to shy away from them because if the bank’s capital were to fall then holders of Coco bonds would be the first to be hit. However Harris, senior credit analyst at Old Mutual says this type of credit is much safer these days.
"The equity layer of the strongest banks has improved enormously over the past few years, which gives us greater confidence to invest in bonds that are further down the capital structure," he explained.
"First and most importantly, the economic backdrop has improved, which helps banks greatly. Banks are essentially magnified versions of the economy and there is no greater example at the moment than the UK banks."
Harris says that a strengthening UK economy means that asset values have increased, such as house prices, and there are now far fewer defaults. He says that both these circumstances, along with a stabilisation in the eurozone, are positive for the banks.
Johnson has managed the £422m Old Mutual Corporate Bond fund since December 2011.
According to FE Analytics, it is a top-quartile performer in the IMA Sterling Corporate Bond sector over that time, with returns of 22.55 per cent.
Performance of fund vs sector since Dec 2011
Source: FE Analytics
The fund also sits in the top quartile over one year. It currently yields 4 per cent, has an ongoing charges figure (OCF) of 1.24 per cent and requires a minimum investment of £1,000.
Harris says that the fund is upping its exposure to a number of the UK banks. Lloyds is one of the best examples of this, because it has created a huge loss-absorbing cushion via its cleansed balance sheet.
However, Harris says the best case to illustrate how far unsecured bank debt has come is Barclays. The team at Old Mutual has just bought its Coco bond, which yields 7.75 per cent.
"Barclays came to the market and raised an additional £5.8bn. This additional equity has given us a greater degree of confidence to move down the capital structure," Harris said.
"After the £5.8bn, the cushion has gone up from £14bn to £20bn. To put that into context, the largest loss Barclays has made over the last 10 years was £624m."
"That was last year in 2012 and that was a time of stress for the banking sector. That £624m figure is very small in comparison to a £20bn cushion. More importantly, we can now withstand another 32 2012-style losses before those bonds become worthless."
Both Johnson and Harris admit that there will still be investors who are wary of holding unsecured bank debt.
In the past, they explain, investors used a "risk-weighted capital number", which was calculated by the banks themselves rather than the leverage ratio they prefer.
"There is no greater example of this than the cautionary tale of Lehman Brothers," Johnson said.
"In August 2008 – a month before its collapse – Lehmans had a risk-weighted capital number, which is the complex and sophisticated measure, of 11 per cent. That was noticeably better than the 8.5 per cent of its counterparty, JP Morgan."
"However, the largely ignored leveraged measure showed that Lehmans' debt to capital was a whopping 30 to 1 while JP Morgan’s was 13 to 1. We all know how this story ends. Lehmans' vulnerability to a relatively small shift in asset value was not captured by the risk-weighted measure as it was by the simple leverage ratio."
"The risk-weighted number was generated solely within the bank itself, leaving us as investors on the outside."
"That risk-weighted measure was open to interpretation and management could maximise profit by how they measured risk," she added.
