Jim has nagged me into finally making my maiden blog entry. Given his revamped M&G Global Macro Bond Fund has just taken a 14% position in European leveraged loans (see yesterday's blog article), it's actually a good time for me to give a brief introduction to the asset class and our thoughts on valuation and risk.

Leveraged loans have been an increasingly popular asset class for institutions and hedge funds over the past five years (in addition to the banks, who have been active participants for some time), and are gradually making their away into the retail space as the regulators become more familiar and comfortable with the asset class. Retail bond funds are now allowed to hold up to 10% of their assets in leveraged loans via something called a Collateralised Loan Obligation (CLO), which is a form of structured credit. Richard's M&G Optimal Income Fund, for example, has a small position in an M&G-managed CLO, while Jim has bought the M&G European Loan Fund for his M&G Global Macro Bond Fund, thanks to his fund's NURS structure.

So what exactly are leveraged loans? Leveraged loans are floating rate instruments that are issued by companies to finance corporate restructuring, such as leveraged buyouts (LBOs). After an LBO, private equity companies have to issue a large amount of debt to fund the transaction, and this is then placed on the target's balance sheet. A relatively recent example was Malcolm Glazer's takeover of Manchester United in 2005. Following the takeover, Manchester United approached a number of institutions in the City asking if they were interested in buying the loans. As it happened, we decided not to (and that's not just because I'm a Leeds United fan). Other companies to have issued loans include Gala, the AA, Lego and United Biscuits.

Senior leveraged loans occupy the most senior position in the company's capital structure, which means that if the company fails and defaults on its debts, then leveraged loan holders are first in the queue to recover their money. The average recovery rate for a senior loan holder has historically been around 80%, significantly higher than the 40% recovery rates that are typical for the average high yield corporate bond holder in event of default. Even though senior leveraged loans occupy the highest position in a company's capital structure, though, they typically have a credit rating of double-B or single-B, which reflects the sub-investment grade equivalent rating that would apply to the borrowing companies. Typically a European loan might pay investors money market rates plus 2.25% (currently 7.85%) compared with around 7.50% for a high yield bond, so given the lower risk profile for loans, they currently look good value.

Another advantage of leveraged loans is that they are floating rate assets rather than fixed assets. In other words, the income paid from leveraged loans is a fixed basis point payment over a reference interest rate, and so the total income paid duly rises and falls in line with interest rates. Leveraged loans therefore have no duration (or interest rate risk) and are therefore particularly attractive in a rising rate environment.

The surge in LBO issuance over the past few years has inevitably resulted in the rapid growth of the European leveraged loan market. In addition, institutional investors have increasingly been able to gain access to the primary market for loans, and now represent 49% of the market, up from 40% in 2005 and 25% in 2004. Interestingly, we have seen US retail loan funds (known as ‘Prime Rate’ funds) enter the European market, as the US managers have increasingly recognised the relative value offered by European leveraged loans. Hedge funds have also become major players, attracted by the high yields, the floating rate feature and the exceptional risk/return characteristics the asset class has demonstrated.

One market development that we're watching closely is the potential for rising risk within new leveraged loan deals, which has been possible due to the soaring demand for the asset class. Although encouragingly, while average debt/earnings was higher at the end of 2006 than a year earlier (with debt standing at 4.25 times earnings, compared with 4.01x in 2005), there was a gradual fall in leverage within transactions as the year progressed (4.23x at the end of Q4, down from 4.43x in the third quarter). Our analytical vigilance is as important now as it has ever been - but this is a very interesting asset class right now.

We've given a relaunch to the the M&G Global Managed Bond Fund, and, as you can see, it has a new name too - the M&G Global Macro Bond Fund. The "old" fund was a fettered fund of funds, invested solely in the M&G bond range, but thanks to some regulatory changes we've been able to adopt COLL "wider powers", which allows us to invest not only in funds, but also in direct holdings and some of the more innovative fixed interest asset classes. In particular I will be able to invest in bank loans, or leveraged loans, via the M&G European Loan Fund run by Dan Gardner - this is the bond asset class we currently believe has the best risk/return characteristics. Yields (typically around 8%) are not far away from those of traditional high yield bonds, yet loan holders have full security over the assets of the company (like a mortgage) if something goes wrong, resulting in historically high recovery rates. Additionally the interest rate paid to investors rises in line with any rate hikes, so if the Bank of England and ECB continue to put interest rates up, the returns on these instruments increase. Ordinary unit trusts and OEICs cannot invest in these loans to any great extent, so we believe the Global Macro Bond fund - by virtue of its NURS regulatory structure - to be pretty much unique in the retail space with its significant holding in them (currently 14%).

So how will I run the fund? The name change to "Macro" reflects the way I think about markets - as an economist by training I will look to put on positions that reflect my long term views of the global economy. For instance I believe that the great wave of baby boomers retiring over the next decade could bring some risks to growth (lower) and inflation (higher); and I believe that sterling looks to be expensive against other currencies, especially as the ECB is likely to carry on hiking as Euroland growth ramps up. So I have been buying floating rate assets (like bank loans, and floating rate notes (FRNs)) which will perform if rates do have to rise, and I have a holding in euro denominated inflation linked bonds, which have cheapened significantly in the last 3 months. "Real" yields have risen from 1.56% to 2.07%, and additionally the euro has weakened against the pound by over 3% over the same period.

If I want to gain exposure to high yield, or sterling investment grade for example, I'll buy my exposure through our own teams' existing funds, thus gaining instant diversification and access to their stock picking. Otherwise I'll invest directly, adding overlays to express my credit, currency and duration views, and using derivatives where necessary. Where property yields look cheap to bond yields I can take a modest investment into that asset class too - again thanks to the NURS structure. With so many interesting developments coming through in the world of fixed interest at the moment (for some reason bond investors love to innovate) we hope to be able to add more (generally higher yielding) bond instruments to the portfolio over time.

This fund sits in the Global Bond sector of the IMA classification - as such its returns will include a higher degree of currency risk than traditional UK based bond funds. Given that the pound is at pretty much its highest levels in living memory (the Bank's Trade Weighted Index goes back to 1990, we're at new highs now, although we have been a little stronger versus the US dollar in 1992 immediately before we fell out of the ERM). I think it's time to take the view that its likely to revert to mean - and therefore that overseas asset exposure makes sense at the moment.

We'll keep you posted on developments on this fund. Also look out for further updates on Richard Woolnough's specialist M&G Optimal Income Fund.

Emails from wine merchants are starting to pop into my inbox with offerings of en primeur wine from the 2005 Burgundy vintage. Thanks - probably - to global warming, pretty much every vintage, from every wine growing region of the world, is at least acceptable nowadays, and the years where the hype declares it to be "the vintage of the century" are increasing. For example, we've had three "vintages of the century" already (2000, 2003, 2005). I'm telling you this because if you're looking for inflation protected assets for your portfolio, fine wine has historically done a very good job. Manesh Kumar's recent book (Wine Investment for Portfolio Diversification) shows that classic Bordeaux wines returned an average 12.3% over the 20 years to 2002, versus 9.2% from the FTSE 100 - volatility adjusted the advantage was bigger still. The last couple of years have seen even greater outperformance thanks to strong global economic growth, and the emergence of new super-wealthy classes in India, China and Russia.

Growers and producers have put their prices up year after year. Wine critic Jancis Robinson has tracked prices of first release Burgundy over the past few years. 12 bottles of Jean Grivot Clos de Vougeot (a Grand Cru vineyard near the village of Vosne Romanee in the Cote de Nuits) would have cost as follows:

2005 - £600 (i.e. about £60 a bottle once tax and duty is added)
2004 - £480
2003 - £594
2002 - £498
2001 - £408
2000 - £402
1999 - £402

A rise of nearly 50% over the period, compared with an increase of under 20% in the UK RPI.

Given the tiny size of the Burgundian vineyards (some make just a couple of thousand bottles a year) supply can't rise to meet demand, as it would do in a widget factory. So if you believe that rise of the middle classes and super rich in the emerging economies is a trend that can only continue, buying scarce, trophy wines would seem to be a good long term bet. The problem is that this market - like that for art - is sentiment and confidence driven, and years when growers get too greedy and confidence falls (like the 1997 vintage in Bordeaux) are followed by long hangovers. Art prices are still 5% below their 1990 boom level. You also need to account for the cost of carry - ie the interest foregone on your wine purchase over the holding period of say a decade or two, and storage costs at about £10 a year per case. In contrast to a boring equity however you can always get drunk on the asset if it falls in price.

PS Talking of the finer things in life, I happen to know that a keen reader of this blog (who for obvious reasons needs to remain anonymous) is in the market for a diamond at the moment. Here's the Antwerp Diamond Price Index. The good news is that despite the rise in commodity prices in recent years, 1/2 carat diamond prices are actually 4% lower than they were in 1995.

More choice is a sign of greater prosperity, right? That tall skinny soya cappuccino extra hot (without chocolate on top) was just what you wanted, wasn’t it? It might not be. It turns out that the more choice you give people, the less satisfied they will be. It used to be the case that if you didn’t like the coffee from the shop it was the shop’s fault for only selling an instant brand. Now, it is your fault for choosing a skinny milk when full fat milk gives the longer lasting foam. The blame shifts to you because you were given so much choice and you made the wrong one. This is the one of the ideas in the book “The Paradox of Choice: Why More Is Less” by Barry Schwartz.

And the relevance to investment? More choices also paralyse decision making. A study found that the participation rate of a pension plan fell 10% when the number of funds on offer went from 5 to 50. You think that you are going to make the wrong choice, as the one you choose probably won’t be the best performer. Even though this will probably be outweighed by the fact that the employer will match your contribution, people avoid the choice.

I watched Prof Schwartz on iTunes as part of the Ted Conference series. This is a series of short presentations by interesting people. You can also watch them online (click here for Prof Schwartz’s presentation) or download to your ipod. Other presenters include Freakonomics author Steven Levitt and Tipping Point author Malcolm Gladwell.

CPI inflation in the UK hit 3% in December. Anything higher than this and the Bank's Governor Mervyn King will have to write a letter to Gordon Brown explaining why inflation is so high. It probably won't read "Dear Gordon, the reason inflation has busted out of the target you set for us is that we've kept real interest rates at exceptionally low levels for too long. Yours, Mervyn." - but it probably should.

The inflation rise was driven by higher transport costs (train and tube fares), furniture and household goods, and recreation and culture. Most worrying was the rise in headline RPI to 4.4%, from 3.9% previously. The latest survey from IDS, a pay consultancy, suggests that in the most recent wage settlements, the benchmark has been the RPI number, rather than the lower CPI number. Higher and higher wage increases could cause inflation to start getting out of control. The most important job the Bank now has to do is to control inflation expectations - this will partly be down to words, with strong anti-inflationary speeches required; but it also requires action, and that includes a further rate hike in the next couple of months.

Elsewhere, commodity prices are worth a comment. The major commodity indices have fallen back a decent way over the past year (CRB down over 15%), largely driven by the setback in the oil price, but also in some recent falls in metals like copper. All good news for inflation, but while there's good news in these "hard" commodity prices, the "soft" commodities have seen some impressive rises of late. In particular the price of corn has just jumped to a 10 year high (to $4.165 a bushel) on the back of falling stockpiles. Demand from ethanol producers has driven this shortage, and the dramatic rises in corn prices is causing some social unrest in some emerging economies where it's a staple food. Worth watching.

Here's the link to the Office of National Statistics new Personal Inflation Calculator that was widely covered in the weekend press. Not that we can get it to work, and we have no idea what an SVG file is, or how to download one. But it's a great idea. Let us know if you can get it working and whether your personal inflation rate is above the national average (likely if you like to eat out a lot and send your kids to public school) or below it (if you have a shoe buying addiction and are looking for a flat screen TV). Incidently, for all the talk of higher council taxes feeding through into inflation, my local council, Hammersmith & Fulham, has just announced a fall in bills of 3% for the next fiscal year (the first fall in over a decade), so it's not all one way.

I thought it would be useful to explain the key positions in the new M&G Optimal Income Fund and how I am making use of the "wider powers", so that readers can get a better understanding of my strategy for international bond (and indeed equity) markets.

A prevailing view over the past 18 months has been that the market's expectations of interest rates have continually been too low, and my long-only bond funds have been very short duration since summer 2005. Back in August 2005, the Bank of England had just cut rates from 4.75% to 4.5%, and the market was pricing in one interest rate cut. How wrong the market was - yesterday's rate hike was the third since August 2005 and there are very likely to be more on the way. This duration call turned out to be spot on and the M&G Corporate Bond Fund achieved top quartile performance in 2005 and 2006, although frustratingly, the fund only just succeeded in breaking even last year. In a long-only bond fund you are always a victim to market conditions.

I believe there are likely to be at least two more rate rises in the UK, and the bond portion of Optimal Income has an exceptionally short duration of just 3 years. On top of this, I sold a significant amount of sterling interest rate futures in December and the beginning of January, which has added to performance since launch (particularly yesterday)

With wider powers, I am now able to accurately express my yield curve view for the first time. I believe global investors are being too conservative on their interest rate forecasts and expect short dated bond yields to continue rising as interest rates go up. Long dated bonds should fare much better, thanks to ongoing support from pension funds. In the US and Europe, I have sold short and medium-dated bond futures, and have bought long dated bond futures. In the UK, long dated bond futures do not exist so I have sold 10 year gilt futures and bought 30 year gilts, which still accurately reflects this view.

As for asset allocation, investment grade corporate bonds form just over 50% of the portfolio. High yield bond valuations are not overly enticing on the whole, and high yield forms 30% of the fund. This is only slightly above the 20% minimum that must be held in high yield corporate bonds in order for the Fund to qualify for the IMA UK Other Bond sector.

Equity exposure stands at just over 10%, and I expect to build this up closer to the maximum 20% limit as opportunities become available. Equity markets still look relatively cheap versus bond markets (and very cheap versus high yield bonds). The equity holdings in the fund are all where a company's earnings yield looks very attractive versus that company's bond yield. Equity selection is made in close consultation with M&G's Equity fund managers and analysts, particularly with the Global Equity team.

Moody's this week published its December 2006 default report showing a fall from 1.8% to 1.7% marking its fifth consecutive annual decline and its lowest year-end level since 1996. Accomodative monetary policy, high levels of liquidity and a willingness to come to the aid of companies in financial difficulty has helped keep rates at historical lows. Worldwide in 2006, a total of 27 Moodys rated corporate bond issuers defaulted on $7.8bn equivalent of bonds compared with 34 and $29bn the previous year. In fact in Europe a mere four corporates (Damovo (telco equipment), Dura & GAL (auto suppliers) and Luxfer (engineering)) defaulted on their obligations in 2006 to the tune of $1.2bn.

The obvious question then is where will the default rate head in 2007 and onwards? Moodys has 2.6% pencilled in for year end '07 though they had been projecting a rise during most of 2006 and got that one wrong! I think the answer requires a two part explanation. Firstly the larger macro picture will prove to be key. If monetary policy remains accommodative through 2007 then liquidity is unlikely to disappear and prove supportive of a low default rate. Secondly the arithmetic behind the default calculation is worth a mention. The default rate during the early part of 2006 was particularly low. Even if we were to see default rates at the same pace of H2 2006 then the default rate is likely to tick up.

In my opinion the likelihood is that Moody's will be proved correct. It doesn't take a genius to conclude that the path of least resistance from a 10 year low is higher, but as ever, timing will be key!

Germany hiked its rate of VAT on the 1st January, from 16% to 19%. Given the size of the German economy, the impact of this will be to raise Eurozone inflation by around 0.3-0.4%. Eurozone inflation is running at 1.9% year on year, only just below the ECB's comfort zone ("below but close to 2%"), so during 2007 we're likely to see price rises sufficient to provoke further rate hikes. There are two other issues - will German consumption collapse as the result of this price shock, and will wages rise to compensate workers for these higher prices?

Firstly consumption. The big worry is that Germany behaves like Japan did in 1997 - the economy there was only just showing signs of recovery, and the authorities optimistically decided that it could withstand a rise in consumption tax from 3% to 5%. It couldn't, and whilst there was a consumption boom immediately before the tax hike came into force (consumption growth ran at a +6.6% yoy rate), it collapsed subsequently, and has really yet to recover fully. There's evidence that Germans have also brought their major purchases forward into November and December, with new car registrations in November up 18% year on year, and retail sales also growing. There's therefore a real risk that there's payback in the next few months, and if the ECB hikes into this consumer weakness Germany's fragile recovery could go the same way as Japan's did in 1997.

Secondly wages. Germany's most important trade union, IG Metall, believes that its workers have had a raw deal over the past year. There's been a significant increase in productivity, yet wage growth has been modest - in other words German company profits have been boosted at the expense of labour. Probably helps explains the great performance of the DAX in 2006 (up over 20%). Union officials are looking for wage rises of 4% for the economy overall, and up to 7% in highly profitable sectors. "The wage increases have to cover the inflation rate, and the VAT of 19% in January has to be taken into account as well. And beyond that workers want to participate in profit growth" said Juergen Peters, IG Metall chairman.

The market's expectation for Eurozone rates in 2007 is that the ECB will hike once or twice, from 3.5% to 3.75% or 4%. Wage hikes of 7% for significant numbers of German workers would certainly put the upper end of this range at risk.

Looking at the broad categories of the UK's RPI numbers here's a brief breakdown of where the inflationary - and indeed deflationary - pressures are occuring. The most recent inflation number we have is for November. The headline RPI was +3.9%, year on year.

Components rising more quickly than average
- Fuel and Light: up 29.5% from a year earlier. Although crude oil prices were only up 11% over the same period we've experienced significant rises in utility bills.
- Housing: up 6.6%. Driven by higher house prices, higher council taxes, and higher mortgage interest payments. These are excluded from the narrower CPI measure, which in part explains why CPI is lower than RPI. See here for the Office of National Statistics explanation for the differences in the measures.
- Housing Services: up 5.3%. Probably related to the stronger housing market. New migrant workers from the new EU members might put downward pressure on this component as they join the UK labour force?
- Food: up 4.5%. A major component of food prices is the cost of energy. Transportation costs are a big input, and fertilizer is often petrochemical based. Difficult weather conditions have also caused food prices to rise. Seasonal food price rises were extremely strong (+10.7%).
- Tobacco: up 4.1%

Components rising slower than the average
- Leisure Services: up 3.1%
- Personal Goods & Services: up 2.9%
- Alcoholic Drink: up 2.8%
- Catering: up 2.7%
- Travel Costs: up 1.5%. May be upward pressure on this as the result of significant rail fare increases in January. However, demand for air travel may fall as a result of recent travel chaos (terror alerts, fog, baggage problems, potential strike action in Q1), which may lead to some bargain flight deals.
- Household Goods: up 1.4%. The China effect - although less pronounced than in 2005 where we had deflation here.

Components currently in deflation
- Clothing and Footwear: down 0.4%. Again the impact of cheap production in the far east is a major factor, but deflation in this sector is much lower than it used to be. In 2002 this sector saw year on year price falls of 6%. Some very mixed signs from UK retailers over the Xmas period means we need to pay close attention to discounting here.
- Motoring Expenses: down 0.9%
- Leisure Goods: down 1.6%

If you're looking for future bargains, the biggest acceleration in deflationary pressures appear to be in TVs (falling at around 20% pa) and cameras (down around 5% pa).

As many of you will be aware we have been concerned about the high yield market for a while now. Historically tight spreads do not, we believe, adequately reward investors for the risks that they are being asked to take although we have been well aware of the technical picture which has proved supportive of spreads. However, a piece put out by JP Morgan yesterday highlighted a few interesting points.

The European High Yield Market (EHY) was characterised in 2006 by a supply demand imbalance. Issuance during the year totalled €28bn. At the same time we saw redemptions of €22bn (ie bonds that matured or were refinanced), coupon payments of €5-6bn as well as what JP Morgan describe as a ‘significant capital inflow’ into the market. These technical go some way to explaining the 11.10% total return for the Merrill Lynch European High Yield Index in 2006. The obvious question, will they persist in 2007?

JP Morgan calculate that €6.2bn of paper is due to mature in 2007. Currently a further €3.5bn of high yield debt is trading above its call price incentivising companies to repay this debt which suggests €10bn may be repaid to investors. This is significantly less than what we saw in 2006. Clearly there will be further unexpected refinancings though I’d suggest these are unlikely to make up the shortfall. Could a large LBO and subsequent EHY issuance prove to be the straw that breaks the camels back?

A recent report from the Pensions Regulator states that the UK's pension fund liabilities exceed pension fund assets by £440bn. The calculation is now a little out of date as it was made on March 2006, so given that bond yields and equity markets have both risen since then, an up-to-date calculation would likely show that pension fund deficits are now marginally smaller. Nevertheless, the estimate of £440bn is considerably higher than many of the deficit figures that have been published in the media over the past few months.

As we have previously argued in this blog, pension fund deficits will shape financial markets and particularly bond markets over the coming years, as companies purchase long dated assets to match with outstanding pension fund liabilities. The £440bn estimate suggests that the pension fund crisis will have an even larger impact than we thought - to put this number in context, the size of the long dated gilt market and long dated corporate bond market combined is around £210bn.