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."
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.
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.
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.
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
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An Exchange traded fund is a security that tracks an index or commodity but is traded in the same way as a share on an exchange. ETFs allow investors the convenience of purchasing a broad basket of securities in a single transaction, essentially offering the convenience of a stock with the diversification offered by a pooled fund, such as a unit trust. Investors buying an ETF are basically investing in the performance of an underlying bundle of securities, usually those representing a particular index or sector. They have no front or back-end fees but, because they trade as shares, each ETF purchase will be charged a brokerage commission.
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.