Bonds that tie you into good yields over time

IN much the same way as people need to borrow money, such as for a home purchase, so governments and companies need to raise funds. This may be for infrastructure projects, like building roads or schools, while firms may want to open a new factory.

One of the main ways to finance such activities is to offer bonds, which are effectively IOUs to the lender. Bonds have a repayment date with the length of time until then referred to as short-dated, medium-dated or long-dated.

Interest is paid regularly until that time. The rate depends largely on how likely the bond issuer is to pay the interest and refund the loan. Such risk assessments are made by credit ratings agencies like Standard & Poor's and Moody's to help investors with their judgments.

A triple A grade issued by S&P is the most credit worthy. Ratings down to BBB are considered "investment grade" with levels below that more likely to default and called "sub-investment grade".

Bonds are bought and sold during their life with the price changing to reflect the economic climate as well as the supply and demand for that loan. Owing to the minimum size of many bonds and the volatility in the market, most savers would be best served by a bond fund. This is particularly the case if seeking higher interest through purchasing "sub-investment grade" bonds.

Most new issues from blue chip companies are not really for individuals, with minimum nominal denominations of 50,000 quite typical. Major high street names like National Grid, Tesco and Vodafone issue bonds but usually beyond the reach of retail investors.

Since European Union regulations require a full prospectus with extensive disclosure and endorsements by directors when bonds are sold in smaller quantities, they opt instead for institutional buyers.

However, instead of placing capital in just one or two firms, it's far less risky to opt for a collective where 75-150 separate issues are held. Corporate bond funds not only bring diversification and a good balance between income need and capital growth but - with the exception of trackers - the experience of a professional manager.

Yields in Government bonds - known as "gilts" - are at record low levels, both in the UK and in other countries, such as Germany.Corporate bonds are generally influenced by the same factors as gilts but have an extra layer of risk as the ability of their issuers to make their interest payments and redeem the loan is linked to the fortunes of the underlying company.

There is the risk of a "bond bubble" if yields are pushed much higher, which would then result in significant capital losses for bond holders. Ensure therefore that your holdings are well up within the "investment grade" sector.

For this reason, Max Horne of the Max Horne Group in Dunfermline is wary of putting much money into corporate bonds and would restrict the level to 10 per cent of a portfolio. He favours the M&G Strategic Corporate Bond, which he has been using for several years. It is still achieving over 10 per cent annually which is exceptional in the current market. Horne says the bond sector gives him "the greatest concern".

Although corporate bonds have enjoyed a very good run lately, "there is still value to be had in the high yield sector if clients are prepared to take the additional risk," says Alistair Blyth, a chartered financial planner at AB1 Financial Planning in Edinburgh.

He has always liked M&G's Corporate Bond and Strategic Corporate Bond for "consistent top performance". According to Lipper research, they have risen by 44.5 per cent and 33.7 per cent over three years. Of the two, the latter is preferred currently "as the managers have more flexibility in where they can invest".

Blyth also likes M&G Optimal Income, Jupiter Strategic Bond, L&G Dynamic Bond Trust, Fidelity Strategic Bond and the Artemis Strategic Bond.

Not all corporate bond funds have been successful. Both AXA Sterling and Gartmore Fixed Interest have lost money over three and five years, the latter by over 9 per cent in both cases.

As a core holding, Iain Wishart of Chartered Financial Planners, Wishart Wealth, like the iShares - Markit iBoxx Corporate Bond which is an exchange traded fund. Always ask about the total annual expenses with such investments as this will be a drag on performance. In this case, it amounts to just 0.2 per cent, which is negligible and may be seven times that figure elsewhere.

"Bond fund managers find it difficult to out-perform the index and market averages," says Wishart. For an actively managed fund, Wishart tips the M&G Optimal Income whose fund manager, Richard Woolnough, is highly regarded. The fund has attracted 2.6 billion. As it has no restrictions on its exposure to government, investment grade or high yield bonds, it should perform well in a variety of market conditions.

Currently the fund has 55 per cent in investment grade, 30 per cent in high yield and the balance in government bonds and equities. On a total return basis, it has delivered an impressive 40 per cent since launch in December 2006.

Some savers, notably pensioners, like corporate bonds for their regular payments.Investec Monthly High Income is just such a fund, investing in highly rated or high yield bonds from around the globe. Co-managed by Kieran Roane and John Stopford, it holds 187 million and typically aims to achieve a high income which can be distributed or rolled up on a monthly basis.

Whilst it is a world fund, all issues are hedged back to sterling and the current yield is an attractive 7.9 per cent. The fund typically seeks to protect investor capital in down markets and this means it sometimes lags in highly bullish bond times. However, over a five year period, it has delivered impressive returns of over 30 per cent.

In view of the disparity between derisory deposit rates at banks and building societies and good performing corporate bonds, the latter provides not only a steady healthy income stream but also ensures savings are not eroded through inflation. However, in view of the warnings from experienced independent financial advisors, now is a time to examine the level of exposure and whether switching into safer, higher graded bond funds might be sensible.

If government stocks are more to your taste, consider City Financial's Strategic Gilt fund which only invests in UK gilts. It aims to offer a superior risk-adjusted return over that of passively holding a conventional gilt portfolio. It accepts lump sums from 1,000 and has an initial charge of five per cent and annual fee of 1.25 per cent.

To ensure tax efficiency, wherever possible, place bond funds in an Individual Savings Account (ISA) which can accept up to 10,200 in this tax year for anyone aged 18 years and older. With reservations from experienced advisors about a bubble building up, consider drip-feeding into funds through a subscription scheme. This ensures you do not have to make a decision on specific timing and that your investment benefits from averaging.