Are corporate bonds yesterday's news?

1 March 2010

There's no need for investors to panic and sell their corporate bonds, as there are still returns to be made, despite speculation that the market is overvalued.

Corporate bonds were the highest-selling IMA sector during last year, with net retail sales of £6 billion. For the first eight months of the year, they topped the sales chart – and then began to dwindle from September onwards.

Ben Bennett, credit strategist at Legal & General Investment Management, however, still thinks they make a sound investment.

He says: "The economy is in a reasonable state and corporations within the economy have real strength.

It's pretty safe to buy the high-yield bonds, but in case of a double-dip recession, I would steer away from those reliant on consumer spending, such as cyclical retailers and financials."

Andrew Wilson, head of investment at Towry Law, thinks yield-hungry investors are likely to stick with corporate bonds and suggests the best way is to invest through corporate bond funds.

These vary dramatically in risk profile, so he believes there should be something to suit everyone.

But not all experts think corporate bonds are a safe bet. Mark Dampier, head of research at Hargreaves Lansdown, describes last year as a once-in-a-generation opportunity and is wary of the knock-on effect sovereign debt could have on the credit markets this year.

"You may have missed the chance if you didn't buy corporate bonds last year – if you've got them now, you might be sitting on some big profits, and I would be tempted to sell," he says.

Corporations use the markets to raise capital, so when you buy a bond, you are lending money to a company and the risk will be rated on the company's likelihood to default on your loan.

Since the London Stock Exchange started listing bonds at the beginning of February this year, it has become easier than ever for investors to access credit markets.


The funds in the sterling corporate bond sector concentrate mainly on investment-grade bonds. This refers to bonds issued by well-run companies that are expected to meet their commitments and therefore yield less than riskier 'junk' or high-yield bonds.

Sterling corporate bond funds are usually bought for their relatively low-risk profile and attractive yield, often paid out quarterly.

Their average yield is currently around 5.5%, which is higher than on cash or government bonds (gilts), and are free of income tax if held in an individual savings account or self-invested personal pension.

Some UK equity income funds offer a similar yield, with the added attraction that their dividends have historically risen over the long term, as have their share prices.

This is obviously welcome for those facing rising living costs. Bond funds, in contrast, find it hard to grow their income as the interest payments on most individual bonds are fixed.

But as the outlook for equity markets remains uncertain, many investors will feel more comfortable with at least some bond exposure.

As it happens, 2009 was one of those rare years when bond funds achieved big gains, largely because interest rates plummeted as governments around the world tried to encourage a return to growth.

Some sterling corporate bond funds achieved total returns of well over 20%, while funds in the higher-risk strategic bond and high-yield sectors notched up even more dramatic gains.

The latter did well because the market decided their higher-risk holdings were less likely to go bust, so there was no need for their bonds  to offer double-digit yields.

Leading bond fund managers warn that last year's big returns were exceptional, and that their supporters should expect a return to business as usual. That's to say, they should hope for similar levels of quarterly payouts and perhaps a modicum of capital growth over time.

However, they admit that interest rates will eventually have to rise from current low levels, which will make it harder to avoid losses on their bond holdings, and some fear that inflation has become an imminent threat.

Nick Gartside, who heads Schroders' fixed income team, warns: "Rising inflation and interest rates are the enemy of fixed-income assets, with the exception of inflation-linked bonds, high-yield debt (where credit is more important) and emerging market debt.

The UK election will also be important to UK bonds. A hung parliament or slim majority could lead to weaker sterling and raise the risks of the UK credit rating being downgraded."

Gartside's colleague, Adam Cordery, thinks this should not dissuade income-hungry investors from holding bond funds.

Manager of the Schroder Corporate Bond fund, Cordery says: "We could do relatively well this year because investment-grade bonds still look fairly cheap relative to government bonds."

Richard Woolnough, responsible for the M&G Corporate Bond fund and the M&G Strategic Bond fund, is less worried about inflation than the Schroder team, but shares their view that corporate bonds remain undervalued.

"We believe corporate bonds can continue to provide a good source of returns for investors, particularly as we expect accommodative monetary and fiscal stimuli to continue well into 2010," he says.

"This is despite corporate bond spreads rallying back to pre-Lehman Brothers levels, with a further tightening in spreads likely in our opinion."

The Invesco Perpetual team, headed by Paul Read and Paul Causer, tends to be more adventurous than M&G and Schroders.

"Corporate bonds had a strong rally in 2009, which will not be repeated, but there are still lots of areas which look attractive, including parts of high yield and parts of bank debt," says Read.

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