Newton uses themes to decide which instruments will bring in the highest sustainable yields THE DAWNING OF the new millennium six years ago raised more dread perils among overexcitable investors than you could shake a stick at. Not so for sober-minded bond traders, who watched impassively as the excesses of the dotcom boom worked themselves out and bond yields began their long and dependable march down. Stewart Cowley, director of investment management and head of fixed income for Newton Investment Management, said in the circumstances bond investment had for a long time been a relatively simple game - buy the longest maturity bond and ride the wave of falling yields to achieve handsome returns for investors. Though this disingenuously simple recipe was no doubt far more complex than it was made to sound, the Mellon Global Bond Fund, managed by Newton, profited accordingly, generating a cumulative return over the past 10 years of 97.7 per cent and earning for it an SCMP Fund Manager of the Year award in the 10-year global fixed income category. But sustaining that sort of performance as interest rates bottomed out and began climbing again - particularly in the present environment where investors are preparing for another turn downwards in the cycle - has become more challenging. 'Things have become a little more difficult. We have had to correctly read the deflationary effects stemming from the development of Asian economies combined with the excess demand for bonds coming out of the western pension fund industry which has been dictating the direction of yields for reasons unrelated to a strict economic interpretation of bond markets,' Mr Cowley said. 'Also, the increasing influence of hedge funds has made markets more volatile than ever before, and we have coped with this by increasingly using derivatives in the portfolio to manage events that used to take months to occur but suddenly became compressed into a matter of days. 'This is true of bond markets but also of currencies. So, as a fund manager, I have had to use all of the modern techniques available under the investment powers of this fund.' Mr Cowley employs Newton's thematic approach to making investment decisions. 'Using themes, I am looking for the big ideas that move the world: the development of the Far East, demographics, developing Europe, the indebtedness of the west ... and then think about which bonds or currencies will react best to these ideas. The fund is made up of positions that are directly related to our themes.' Ensuring that those themes are executed to the best advantage of the fund requires the help of a global team of bond and currency dealers who 'make sure our clients get the best prices at the time that transactions are placed'. The environment in which the fund is managed may be more or less complex at any point in the investment cycle, but the mandate remains simple. 'We have a single aim - to get the unit price to rise consistently over time.' The mandate allows the fund to invest in all of the government bond markets in developed nations and up to 10 per cent in emerging markets. The fund manager may use forward foreign exchange contracts to protect from currency movements and bond derivatives to protect the fund from occasional shocks. It offers retail punters an opportunity to get exposure to the global bond and currency markets in an uncomplicated way not available to them as small investors. 'If they wish to use corporate bonds or emerging markets in their overall portfolio they can allocate assets around the Mellon Global Bond Fund without fear of overlap. It is this simplicity, combined with the long-term performance track record, that has helped it grow to nearly US$950 million over the past few years,' Mr Cowley said. But what of the immediate outlook? Mr Cowley and his team of researchers and analysts believe that bond yields, especially in western bond markets, may decline even further. The deflationary effects of the development of Asian capitalism, the internet and other factors are not fully played out and in the next economic slowdown bond yields may fall to all-time lows. 'Add on top of this the global demand for bonds from pension funds, and you understand why our research points to a positive investment in bonds in 2006 and 2007.' Currencies could also help. The US dollar is set to devalue against the major reserve currencies of the world and, although it will not be a straight line, the opportunity of adding to the total return of the unit price through owning currencies such as the euro, Canadian dollar, South African rand and even the Japanese yen could be substantial. He said the allure of investing up the risk curve to spice up returns against a background of tumbling yields was not for Mellon. 'It's true that some managers have been drawn into this idea but in the Mellon Global Bond Fund we keep the quality high. However, we have the mandate to diversify into higher-yielding markets as we expect, for instance, emerging markets to converge to the developed markets in yield because of the extra economic growth and opportunities globalisation offers to these countries.' Mellon research suggests that the US, British and other European interest rate cycles are all but over. 'There are good reasons why central banks will be much less active than they were in the past.' Against this background, investment decisions are being made with less of an eye on central banks and more attention on the real economy. On a theme basis Asian issues are in favour. 'We like the Far East. Long-term, these are going to be the winning nations. We have owned the Singapore dollar from time to time and the Japanese yen as symbols of this theme. But because we like to have a diversified world view, no particular theme dominates the portfolio. It is the sum of all of our ideas.'