Playing it safe in the fixed-interest market

It's fair to say that fixed-interest investments are never going to shoot the lights out when it comes to performance; their appeal lies in the fact that they can provide a comparatively safe haven during troubled times. Indeed, many top financial advisers have been telling their more cautious clients to devote at least a third of their investments to fixed interest.

Loans made to reputable governments - including UK gilts - are the safest form of fixed-interest security as governments are less likely to default. But while corporate bonds - loans made to companies - are that little bit riskier, that is compensated for by better yields.

The yield is usually much higher than on shares, and is even more attractive if they are held in an ISA, as payouts on bonds are tax-free within an ISA, whereas dividends on shares are not.

But there are drawbacks. One is that the payouts on bonds do not grow over time, so their purchasing power is eroded by inflation. Also, most bonds are redeemed at the same price as they were issued a few years earlier, so it's hard to make significant capital gains. In contrast, dividends on shares should keep rising over the years - as can share prices.

However, while bonds may not have the money-making potential of equity-based investments, the market for them at the moment looks attractive. One reason is that their value tends to rise when interest rates are falling, as many expect them to do over the coming year as worries about the economy continue.

Another is that bonds should be less badly damaged than shares if the issuing company gets into trouble. This is because interest on bonds must be paid in full before any dividends, and bond holders must be fully repaid before the shareholders get anything if the company is forced to wind up.

When times get really tough, however, even bonds can lose value - look at the way bank bonds plummeted after the credit crisis surfaced last summer. But the better bond fund managers foresaw the dangers in the banking sector and sheltered most of their assets in gilts or in bonds issued by more defensive companies. Some of those managers believe that some of the worst hit - and therefore highest yielding - bonds could be heading for a rewarding recovery.

Staying defensive

But Schroder Corporate Bond fund's Adam Cordery remains defensive. "I will only ease up when the headlines say no one will ever buy corporate bonds again," he says. "We expect a lot more bad news on the economy. There will be a lot of noise about companies going bust - even if only a few actually do - and that means the prices of all corporate bonds will suffer."

The trust's cautious positioning should protect investors if things deteriorate further, but may mean it misses out on any rallies. Cordery expects this year's yield on the fund to be around 6%.

John Anderson, who manages Rensburg Corporate Bond Trust, is more upbeat. He lifted its gilts exposure to 25% in 2006. This hurt its performance in the run up to the 2007 setback, but paid off handsomely thereafter. He has recently been cutting back on gilts, because he believes the markdowns in many corporate bonds have gone far enough.

"The spreads [the difference in yield between different bonds] were forecasting a level of bank defaults as great as in the Great Depression, so I've been bottom-fishing," he says. "But I'm still overweight in bonds issued by companies in defensive sectors like tobacco and food retailers."

The Invesco Perpetual Corporate Bond fund boasts the best five-year figures in the Corporate Bond sector, and its manager, Paul Reid, believes it's heading into a period when it can achieve an above-average yield plus genuine capital appreciation.

If he gets it wrong investors will suffer, but his record indicates he has a better chance than most of getting it right.

"Things are getting very interesting," he says. "Credit spreads have been tightening since the Bear Sterns rescue package, the Royal Bank of Scotland rights issue was fantastic news for their bonds, and for other financial companies bolstering their balance sheets. We'll have more economic shocks, but a lot of that's priced in, and a lot is being done to fix markets from a fixed income point of view.

"If you have your eyes open, there are some great opportunities around."

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