Warning that current boom in corporate bonds may have sting in the tail

CORPORATE bonds are currently the go-to asset class for investors nervous about equities and looking for regular income.

Private investors and pension savers have piled billions of pounds into corporate bond funds, making it the best-selling sector in five of the first six months of this year, figures from the Investment Management Association show.

Some of the best-known vehicles have  attracted inflows of more than £1 billion over the past year alone.

Yet their popularity comes with a possible sting in the tail as fears grow of a potential liquidity crisis that could force some funds to slam the doors on investors.

The Financial Services Authority (FSA) last month wrote to fund firms asking how they would be able to cope with large-scale investor redemptions.

The City regulator is anxious about the size to which some funds have grown at a time when the supply of new corporate bonds is slowing down.

It asked firms to stress test their funds and provide details of how they would meet  redemptions.

The lack of liquidity in the market has forced some firms to look at ways of stemming the amount of money going into their corporate bond funds to ensure they are still able to cover redemptions should a correction spark an exodus of investors.

One of those firms is M&G, which offers the £6.3 billion corporate bond and £5.1bn strategic corporate bond funds.

While both hugely popular funds remain open, M&G wants to reduce the rate at which money is flowing into them, although it insists they will remain open to business.

It’s an unusual step to take, and bond fund managers generally believe they have sufficient liquidity to accommodate any withdrawal requests.

But Brian Steeples, managing director at Glasgow IFA The Turris Partnership, said investors can take nothing for granted.

“Investors should be aware that no fund can accommodate everyone wanting to leave all at the same time.

“Investment should therefore be for at least a five-year period. If you can’t commit to five-year investment , do not invest in corporate bond funds.”

However, there’s no reason for investors to panic, according to Ken Taylor, director of Mackenzie Taylor Wealth Management.

“The liquidity concerns are valid in one sense, but I would question why dramatic redemptions might suddenly occur. If there are significant withdrawals from corporate bonds, where is the money going to be placed?

“Equities do not perform particularly well in a rising inflationary environment, so to suggest everyone is going to simultaneously exit bonds is nonsense.”

The appeal of corporate bonds is the current climate is understandable.

Returns are often comparable with those available from equities and they also provide a regular income, all with less risk to capital.

Over one, three and five years the average fund in the corporate bond sector has returned 7.6, 29.5 and 27.8 per cent respectively, according to Trustnet.

Taylor said: “The informed view is that investors are being well rewarded for taking risk in this asset class, as the premium being offered over gilts is unusually generous at present.”

Corporate bonds also look increasingly attractive in the context of a sovereign debt crisis that means the focus is less on companies going bust than on countries defaulting.

“This begs the question as to whether it is riskier to lend to a government than to a company,” Taylor pointed out.

“Would you rather lend money to the Spanish government or Telefonica, for example? Yet you are paid more to lend to the company, whilst the country is effectively bankrupt.”

The threats remain, however. While inflation – the traditional enemy of the fixed interest investor – is likely to remain benign for some time, the shortage of new bond  issues is becoming a problem.

It reflects increased caution among companies focused on reducing debt levels rather than issuing new debt. It also implies that a higher proportion of the bonds that are being issued are by companies with a higher risk level.

That’s why Taylor warns that investors in corporate bonds needs to tread carefully. “We should, however, anticipate an increase in defaults, so more than ever it is extremely important to be selective in terms of the bonds you hold.”

Homework is the key to getting the best out of corporate bonds in the current market. Knowing the level of risk that a particular fund will expose you to is essential. As Steeples pointed out, it’s worth investors getting a good idea as to the composition of any fund they invest in.

“Be clear on the types of assets that are held within the fund; be clear on the spread of assets between the different sectors of the investment market; and be clear on the geographic spread of assets,” he advised.

“Also and be aware of the top five holdings in the fund. This will give you an indication of what the manager is doing and what he currently favours.”

Be wary if a bond fund appears to have a lot of exposure to certain higher risk sectors, for example. The financials sector, including banks, is currently considered among them.

Taylor believes the extent to which different funds are exposed to financial services debt will be central to the fortunes of corporate bond funds over the coming years.

“Being overly exposed to this sector is extremely risky, and will continue to be so for quite some time yet. This factor alone goes a long way towards explaining the significant divergence in performance of some of the leading (and biggest) corporate bond funds over the past two years,” he said.

“As with any investment, do your homework and make an informed decision as to what it is you are investing in.”