Warning for savers over bond risks

Many investors may be unaware of the true potential for losses when they put money in corporate bond funds, writes Jeff Salway

SAVERS starved of income from cash accounts and turning to corporate bond funds for low-risk growth have been told by the City watchdog to check what they’re getting into.

The Financial Conduct Authority (FCA) last week issued a new statement outlining the risks of the funds, amid concerns that they are wrongly perceived by many people as being risk-free.

It warned in particular of potential liquidity issues, where investors could struggle to sell their holdings in the event of volatility in the corporate bond market. That market has shrunk in recent years, said the FCA, creating the possibility that fund managers could struggle to sell sufficient bond holdings to meet investor redemption orders.

The regulator’s latest intervention came two years after it told asset managers to ensure they could continue to meet redemptions, on the back of evidence that investors were piling into the funds even as liquidity levels fell.

Investors should also be aware of the impact of interest rate changes on bond values, the FCA said. It pointed out that an increase in the Bank of England base rate, which may happen before the end of the year, would push bond prices down.

And while the regulator stopped short of suggesting there is trouble ahead in the bond market, experts said investors may have savings in corporate bond funds that leave them at greater risk of losses than they realise.

John Bell, financial planner at Carbon Financial Partners in Edinburgh, said many investors were lulled into a false sense of security by the low-risk ratings that credit agencies often give to corporate bonds.

“‘Low risk’ is relative, and although bonds may be less risky than investing in equities, they are much more risky than holding cash in a bank account,” he said.

“Although bond funds can produce a higher rate of return compared to deposit accounts, they can also fall in value and are more costly to invest in.”

Fears of a bond bubble were voiced early in 2013 as demand from investors sent prices soaring and yields tumbling in the opposite direction. That didn’t materialise, however, and investors have piled into equities over the past year as stock markets have maintained their surge.

But it remains the case that savers should only invest in bond funds if they could cope financially with short-term losses and leave their capital untouched for several years, said Bell.

The latter point is crucial, given that getting money out of a fund can be tricky when liquidity issues strike.

The 89 funds in the Investment Management Association’s corporate bonds sector must invest at least 80 per cent of their assets in “investment-grade” companies, considered least likely to default.

Investing in the right kind of bond fund is also important, as some expose investors to greater risk than others. At the more cautious end are those focusing on the investment-grade companies, while others also invest in high-yield bonds where the default risk is higher, although many funds seek a blend of the two.

“But these bring with them a high degree of risk relating to the judgment of the manager,” said Bell. “Therefore, understanding what is ‘under the bonnet’ is crucial before investing.”

He prefers to use funds which invest in short-dated, high-quality bonds issued by governments (gilts in the UK) and central banks.

“Research shows that investors are typically not well rewarded for investing 
in higher-risk, less-liquid corporate bonds compared 
to lower-risk, more-liquid government bonds,” said 
Bell.

“The extra return for investing in riskier bonds compares poorly to the extra return for taking the equivalent risk with equities.”