Soap box: Your word could well be your bond

Published on Friday 28 November 2008 19:37

WORKING in financial markets on a daily basis can sometimes place you too close to the action.

It's easy to lose a proper perspective of events, so I relish speaking to friends and listening to their perception of events.

Inevitably we discuss the state of markets and it's interesting to hear that while a month ago the real worry was the safety of the cash in the bank, the major concern now is the impact falling interest rates will have on deposit savings.

Well, for a change I think there is now a genuine opportunity for savers to consider moving beyond cash deposits in anticipation of achieving a better return.

There is little doubt that rates will fall further – possibly to virtually zero – as we get to grips with the spectre of deflation rather than inflation. It will become necessary to lower rates to kick-start the economy and stave off such a threat. House prices are now falling rapidly, car sales have collapsed and unemployment is beginning to rise significantly. In this depressing scenario, the opportunity lies in fixed-interest markets.

When the Japanese property bubble burst in the late 1980s and its banking system faltered, interest rates were cut to zero due to deflationary concerns. This produced a spectacular rally in government bonds, as yields fell from around 8 per cent to 0.5 per cent and investors in these bonds enjoyed annual returns of around 9 per cent. There is already a significant rally in bonds in the UK, but it may have some way to run yet despite the anticipated issue of government debt to meet spending.

The really interesting opportunity lies in corporate bonds, where returns are highly likely to beat cash over the next year or so.

The spreads on these bonds, which is to say the additional coupon or interest paid to compensate for the risk of default over government bonds, are at levels not seen in living memory. The markets are anticipating default rates of around 40 per cent among investment-grade bonds over the next five years, while in the high-yield sector the figure is an unbelievable 70 per cent. In short, I believe that investors are being over compensated for the risk of defaults among issuing companies.

For investors, the intelligent way to access this opportunity is to seek professional advice and to buy a well-managed corporate bond fund. This will significantly reduce the risk factor, as the fund will probably hold at least 100 individual bonds and also benefit from a high degree of company analysis and research, plus active management of the portfolio. Interestingly, the number of likely funds is fairly limited so selection is not particularly difficult.

As always, seek to understand what it is you are investing in.

Corporate bonds might not be the most exciting investment vehicle, but it is worth noting that at least one such fund has produced better returns than the All Share index over the past one, three, five, seven and ten years. Now that is something well worth considering.

• Ken Taylor is director of Mackenzie Taylor Wealth Management.