Corporate Bonds: The risks involved

Interest in corporate bonds cooled last year as the European sovereign debt crisis sparked new fears over liquidity and potential defaults.

But fixed income funds have been bestsellers among private investors for several months now, with corporate bond funds the most popular in five of the last six months. That spike has prompted warnings for investors to be on the look-out for another corporate bond bubble.

A survey of investment advisers last week by CFA UK, a trade body for investment professionals, found that 49 per cent now think corporate bonds are overvalued. Almost eight in ten believe government bonds are overvalued, suggesting the flight to safe haven assets risks creating a fresh bond bubble.

Will Goodhart, chief executive of CFA UK, said: “While fixed income securities have been attractive on account of their perceived ‘safe haven’ status, our survey suggests that they may no longer offer good value.”

That both government and corporate bonds currently appeal to private investors is clear from the latest fund sales figures, however.

The three top selling fund sectors in February were corporate bonds, strategic bonds and global bonds, according to the Investment Management Association (IMA). Further evidence of a bond fund boom came from Skandia, which recently reported that the fixed interest sector accounted for almost a quarter of all sales in the first three months of this year. All but three of its top ten-selling Isa funds in March were fixed income.

This comes at a time when confidence is gradually returning to equity markets, buoyed by the relative stability of global stock markets so far this year.

Yet the popularity of bond funds among UK investors is unsurprising, given their promise of decent income (corporate bond funds are yielding 4 to 5 per cent on average) but with typically less risk than equities.

Ken Taylor, director of Mackenzie Taylor Wealth Management in Nairn, said: “A lot of the support for corporate bond funds is a direct result of the demand for income from investors, particularly those who have traditionally relied on deposit accounts and who are perhaps not comfortable with the perceived risk of stock markets.”

Adrian Lowcock, senior investment adviser of Bestinvest, said investors were split between investing more money in emerging markets, in search of greater growth, and opting for more defensive options, such as bonds.

“Many investors understand that cash is not providing any returns and indeed actually losing investors’ money, given the effects of inflation, so they have moved some of their savings into investments,” said Lowcock. “Naturally, with this money they are less willing to take on significant amounts of risk and therefore are looking for something less volatile and less risky with a fixed income.”

So the rationale for investing in fixed income may be straightforward. But it’s not that simple, because there are various ways of investing in sovereign and corporate debt. And beyond that, there are several different types of funds providing exposure to UK and global bonds.

UK investors traditionally opt for UK corporate bond funds, with a leaning towards those focusing on investment grade debt (considered the least risky).

Lowcock said: “Corporate bond funds offer an attractive yield of around 4 per cent which is above inflation and some potential for capital growth. Most investors are focusing on the lower risk corporate bond funds or on strategic bond funds, as these are less volatile.”

But while the combination of income and relatively low-risk growth is appealing, there’s a danger that investors are diving in with unrealistic expectations.

“I well remember when corporate bond funds first gained popularity back in the late 1990s, and people ploughed into those bond funds offering the highest yield figure, only to end up disappointed,” said Taylor.

The average fund in the IMA corporate sector has grown 41 per cent over three years, according to Financial Express. That is outstripped by the performance of the typical strategic bond fund, up 45.5 per cent over the same period.

Strategic bond funds give the manager greater freedom to invest anywhere in the bond market and move between investment grade and riskier high yield corporate bonds.

The flip side of this is that investors may find their money is in funds exposed to more risk than they’re comfortable with. If you’re investing in a strategic bond fund, it’s worth taking a look at a funds website such as www.iii.co.uk or www.trustnet.com to find out how much of it is invested in high yield assets in which the default risk and potential returns are higher.

Where strategic bond funds can add value is in giving investors some access to the high-yield end of the market without them having to take the risk of putting their money in a fund specifically targeting high yield bonds.

“Rather than diving into a single high yield fund, which can be extremely dangerous, the smart investors should be seeking out strategic bond funds, which allow their managers to move between pure investment grade and high yield, to manage duration and essentially seek exposure to the most attractive sectors as the cycle changes,” Taylor explained.

Lowcock and Taylor both favour the M&G Strategic Corporate Bond fund, which currently yields at 3.1 per cent.

“Another good choice would be the Jupiter strategic bond fund, which has delivered very good returns,” added Taylor.

As for government bonds, or gilts, the government’s quantitative easing (money printing) policy has sparked fears over a bubble in their value.

That’s why Brian Steeples, managing director of The Turris Partnership, warns against investing in traditional government bonds: “Conventional gilts and gilt funds do not offer good value prospects at the moment – do not buy them for at least another couple of years.” The index-linked gilt market represents better value in the meantime, according to Steeples.