Diversification key for investors in uncertain economic environment,

says Strategic Bond Fund manager

As the UK government attempts to deal with burgeoning debt levels in the next year, low growth and inflation are likely to mean a challenging environment for bond investors, says Ian Spreadbury, manager of Fidelity International's Strategic Bond Fund.

Speaking at the Fidelity 2010 Investment Forum, Spreadbury warned that the UK's debt levels are putting the UK economy at significant risk, highlighting the need for diversification in investments.

He said: "Over the last 20 years total debt in the UK economy has been rising inexorably and this includes household, company and Government debt to the extent it is now around 4.5 times GDP.

"I am not saying we cannot successfully run the economy with a high level of debt, I think we potentially can, but the risk is very high.

To address this, debt will have to come down otherwise interest rates will have to rise.

Spreadbury believes interest rates are unlikely to rise which leaves the Government with no option but to bring debt levels down".

Addressing some of the concerns about the UK economy, Spreadbury says: Ratings downgrade - This is probably not on the cards in the short term, although it could be an issue if the Government fails to address debt levels following the election.

But a downgrade might not be as bad as some expect: "There are a number of big economies rated lower than AAA, including Japan, Spain, Italy, Belgium and Ireland.

They are all managing to fund themselves and while it wouldn't be helpful if the UK is downgraded, it would not be a disaster.

Quantitative easing - An announcement on whether quantitative easing will continue is due later this week, and concerns have been raised that there will be no buyers of Gilts if it ends.

However, this is unlikely: "I think we will fund it.

Investors are currently earning very low rates in cash and so there is an incentive for them to buy Gilts yielding around 4%.

There are also substantial savings in Asia that could find a home in Gilts, particularly with Sterling at lower levels.

Monetary tightening - Following a period of monetary easing, investors have expressed concern about aggressive monetary tightening.

However, the Government is well aware of what the impact of a hike in interest rates would be: "If interest rates go up, it will cost a lot to service debt to the extent that it could easily swamp any recovery.

In this uncertain environment, Spreadbury says investors should be looking to allocate strategically across different asset classes to reduce some of the risks.

The Fidelity Strategic Bond Fund aims to achieve an optimum asset allocation by investing across high yield, investment grade, inflation linked and conventional government bonds.

Spreadbury is currently favouring corporate bonds over Gilts and has brought his government bond exposure down to around 6% as a tactical bet within the fund.

He says: "Currently, I am not that keen on the value of government bonds relative to corporates.

I'm currently running high yield at around 27% and investment grade corporate exposure is around 64%.

"In the very long run corporate bond yields tend to track nominal GDP in the economy.

At 5-6% currently they offer pretty good value with expectations for nominal GDP this year at around 4%.

I think that still makes corporate bonds still quite decent value.

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