Corporate bonds can still provide an income stream

If you need an income from your savings, corporate bonds are still an attractive option for 2010, say bond fund managers at leading asset management groups.

With net yields of up to 6% available on corporate bond funds, they are paying significantly more than cash deposits, but without the potential volatility of equities. However, the recent problems in Dubai highlight the fact that bonds are not risk-free.
Bonds aren't expected to produce the bumper capital gains investors enjoyed in 2009, but according to Jim Leaviss, head of retail fixed interest at M&G Investments, "there is more to go for".
Corporate bonds, issued by companies when they need to borrow money from investors for a specific period, performed spectacularly well in 2009, after they fell from favour at the end of 2008 as the global credit crisis took hold.

Prices collapsed as the market priced in potential default rates of 30%; a level not seen since the depression of the 1930s. As a result, bond yields rose significantly, which made them increasingly attractive relative to cash.

Bond prices have risen since then, but as Leaviss points out: "Corporate bonds still yield considerably more than government securities. Despite the fact we are coming out of the recession, investors are being paid around 2% more on investment-grade bonds and 5% to 6% more on high-yield bonds."

Higher-than-average default rates are still reflected in bond prices, even though company failures have been below initial expectations. John Anderson, head of credit at Gartmore Investment, says: "Bond defaults did rise, but did not go up sharply. They are now showing signs of peaking at around 10% to 12%."

The best-selling funds in 2009 were those specialising in investment-grade corporate bonds issued by the most creditworthy companies rated AAA to BBB. But these funds often include some exposure to high-yield, lower-quality bonds, where prices rose even more strongly in 2009.

Low-grade bond winners

Peter Harvey, manager of Cazenove Strategic Bond, points out: "It was bonds rated BBB, the lowest grade of investment bonds, that did particularly well in 2009. They rose about 30%. Much of the returns came from distressed financial bonds issued by bonds and insurance companies."

Along with M&G's Leaviss, Harvey remains a big fan of BBB-rated bonds. "The differential between the average yield on a 10-year gilt of around 3.6% and the average yield of 6.6% on a BBB corporate bond is at an historically high level," he explains.

"Normally, the differential is less than 3% so the gap is almost as high as it has ever been. If you can capture these yields now, it is definitely 'attractive'."

Harvey's fund also invests in the defensive end of the high-yield market in BB-rated bonds, where he says he can find good opportunities in issues with yields of up to around 6% above gilts.

They include companies such as Allied Domecq and International Power. He says: "You have to be pretty bearish to think these bonds will go bust."

Beyond sterling

Investors do not have to stick to funds investing in sterling-denominated bonds. Global, European or emerging market bond funds are also available, but their returns are affected by currency movements.

Guy Skinner, manager of Scottish Widows International Bond fund, explains: "In 2008, a lot of the return from overseas bonds came from the depreciation of sterling against other currencies. In 2009, sterling rose so returns were lower.

Therefore your view of future returns will partly depend on sterling in 2010. Our view is that sterling may rise a little initially, but will be under pressure at the end of the year, which should be good for returns."
Some standard corporate bond funds have scope to invest outside the UK, although they will normally hedge the currency risk. Leaviss points out that if currency is taken out of the equation, the impact of globalisation means yields are virtually the same around the world.

However, it is possible to access bonds of companies not available in the UK.

Paul Read, co-head of fixed income at Invesco Perpetual, explains the attractions of overseas bonds. "Following the introduction of the European single currency, one of the major changes of the past 10 years has been the increasing size and depth of the eurobond market.

"Being able to buy euro or dollar bonds allows you to diversify and buy bonds you can't get here. One reason to move away from sterling would be to invest in high-yielding bonds; many of which are euro-denominated."

High-yield bonds are an area Read finds attractive.

Bond funds will undoubtedly remain attractive while short-term interest rates on cash deposits stay low. Read believes they will stay low for a while. A potential fly in the ointment is the possibility of a rise in inflation, as it means the value of fixed income is eroded.

Inflation may rise due to the extra money governments have pumped into their economies, but Read is not worried. "Unemployment is too high and there is an output gap to make up. I don't see pricing power returning until 2011 or 2012."
Another possibility is deflation. This would be beneficial for those holding gilts and investment-grade bonds. But managers do not believe this is a serious threat either.

A key feature to consider regarding the top-performing bond funds over the past two years, was whether managers were holding, or not holding, financial bonds at the right time.

Although corporate bond exchange traded funds are now available, they track indices that contain a large proportion of financial bonds, so investors were hard-hit when these bonds fell out of bed.

Leaviss says: "A crucial difference between equity and bond indices is that with equity indices you are backing winners - the bigger the company the more successful it is.

"With a bond index you are backing the losers; the companies who need to borrow more money." So paying an active manager should be money well spent.

Government bonds

UK government bonds are regarded as a safe place for your money because the government is not expected to default. Gilts are expected to provide a better return than cash in 2010, according to Aberdeen Asset Management.

And they benefit from their 'flight to safety' quality when investors are spooked, for example when Dubai's financial problems emerged in November 2009.

Invesco Perpetual's Paul Read explains: "Government bonds were very expensive at the beginning of the year. Prices have since fallen and they offer better value, but there is still scope for them to drift lower."

Concerns about the gilt market centre on the government's high level of issuance over the next few years and the large amount bought by the Bank of England under the quantitative easing programme, which has helped support prices.

What happens when the central bank stops buying is "the 64 million dollar question", says John Anderson, head of credit at Gartmore.
Comments by international ratings agencies over the possibility of downgrading the UK's credit rating from AAA have also spooked investos. But M&G's Jim Leaviss says: "It would not be the end of the world. It is not the only reason investors buy UK gilts."
Guy Skinner, government bond specialist at Scottish Widows, says: "Don't forget, other governments have the same problems as the UK. They have also been issuing bonds to fund rescue packages, to offset falling tax revenues and to pay for the costs of increasing unemployment."
He believes government bonds will always be in demand among investors, as they are more liquid and easier to trade than corporate bonds, especially in a crisis.

Inflationary scare

Ideally, if economic growth picks up and tax revenues improve, governments will reduce their borrowings. Brian Weinstein, managing director and portfolio manager at BlackRock, says if growth is not sufficient, goverments may encourage inflation, which he believes is a risk in the medium-term.
Inflation-linked government bonds are a way of hedging against this risk and Weinstein says they look attractive, as the market is pricing in relatively low and stable inflation.

Investors who see deflation as a greater danger should stick with conventional government bonds. Deflation will lead interest rates to fall further, so the value of fixed returns on these bonds will be enhanced. But companies will be unable to raise their prices and could struggle to pay their debts.

Actively managed funds of government securities are available, but the lowest-cost option is an ETF that tracks one of the bond indices, such as the FTSE All Stocks Gilt index.

Stockbroker Killik & Co favours shorter-dated gilts (such as the iShares FTSE Gilts UK 0-5 years) over longer-dated issues; and emerging market sovereigns (the iShares's JPM Emerging Markets Bond Fund) over developed markets.

This article was originally published in Money Observer - Moneywise's sister publication - in January 2010

More about