A path through the corporate minefield

The UK corporate bond world is young, small and volatile. Continuing our series on investment vehicles, Alison Eadie looks at the corporate bond personal equity plan

Corporate bond personal equity plans are new financial animals based on a young and developing market. British companies only started to issue bonds in any volume from the mid-1980s when inflation began to fall. The UK corporate bond universe is still very small compared with the longer-established equities market. Barclays de Zoete Wedd puts the total value of Pep-qualifying investments at pounds 32.2bn. The value of UK ordinary shares, by contrast, is around pounds 840bn.

Ian Spreadbury, manager of Fidelity's MoneyBuilder corporate bond Pep, estimates that there are around 100 reasonably liquid "qualifying" corporate bonds (ie issued by UK companies not in the financial sector). He excludes preference and convertible stocks, which MoneyBuilder avoids as too volatile. The number of issuers is less than 100 as some companies have more than one qualifying bond.

Because of the limited market, MoneyBuilder uses the half of the fund that does not have to be in "qualifying" bonds to diversify into other "non-qualifying" fixed-interest stocks. The choice of investments then rises to 500 bonds, plus about 70 different government stocks, or gilts. At present MoneyBuilder is spread 55 per cent in qualifying bonds, 23 per cent in gilts and 22 per cent in financial, foreign-issued Eurosterling and other non-qualifying bonds.

The pounds 60m fund now holds around 50 investments, which will rise to 60 as more money flows in. Designed to appeal to building society investors, the emphasis is on avoiding risk. "Investors want stability and security," says Mr Spreadbury. For that reason no one corporate issuer accounts for more than 3 per cent of the portfolio, and the "non-qualifying" allocation is used to diversify into good-quality credits. These presently include European Investment Bank, Bayerische LandesBank and Abbey National.

MoneyBuilder uses a stock selection rather than an interest rate-driven investment strategy. Mr Spreadbury believes that positioning a fund according to the direction of interest rates carries a higher degree of capital risk. Rates are notoriously difficult to guess right. He prefers to neutralise the effect of interest rates and avoid excessive capital volatility through buying a mix of long and short bonds from 30 to five years' maturity. "We put our bets on where we have done our research," he explains.

This research involves close liaison between the fixed-interest team and Fidelity's equity analysts. Mr Spreadbury looks closely at corporate balance sheets, debt-to-equity ratios and cash flows to see if companies can finance capital expenditure and cover interest bills comfortably. He checks the value of corporate assets, to see if they are over- or under- valued in the accounts, and assesses the quality of management. He stresses the importance of meeting senior management on a regular basis.

Much time is also spent poring over prospectuses to establish how bonds rank relative to other company debt and whether they have a charge on assets or any other built-in protection. Some bonds can be sold back to the company at par if the company restructures and the bonds fall below their credit rating. Most cannot.

"You also have to think laterally about what can happen to a company to change its credit rating," Mr Spreadbury says. Lateral thinking is very much required in the present takeover bonanza on the London stock market. It has proven conclusively that what is good for shareholders can be bad for bondholders.

MoneyBuilder has shied away from bonds issued by utilities, particularly those of regional electricity companies, because as share prices have soared on takeover activity, bond prices have fallen.

Bond prices reflect nervousness about increased indebtedness needed to fund takeovers. Granada and Forte bonds have both underperformed since Granada launched its bid for the hotels group, as the combined group is likely to be more highly geared than the companies individually.

Out- and under-performance are measured by the bond's behaviour relative to an equivalent maturity gilt. The higher yield on bonds over an equivalent gilt compensates for its extra credit risk and degree of illiquidity. Mr Spreadbury's job is to ferret out mispriced bonds. The market is not perfect and recently got British Gas wrong, he points out. British Gas bonds have recently been downgraded from triple-A to double-A-minus and single-A1. MoneyBuilder tends to invest in the better credit risks of single to triple-A bonds, but will consider a triple-B if internal research indicates that the market has the rating wrong.

Mr Spreadbury believes that yield margins, which are historically very tight, (ie close to gilt yields), will widen. He argues that the supply of gilts will diminish as the public sector borrowing requirement falls, making gilts more expensive and reducing the yield. Corporate bond supply, however, is expected to increase as companies rush to raise cheap money. Bonds will get cheaper, yields will edge higher, and margins will widen.

The wild card, admits Mr Spreadbury, is the Tessa effect. A whopping pounds 16bn in tax-exempt special savings accounts matures in the first quarter next year and an unquantifiable chunk of it could end up in corporate bond Peps. If demand proves greater than supply, bond yields could even go below gilt yields, Mr Spreadbury says.

Despite this, Mr Spreadbury is sticking with his prediction of margin widening longer-term, and has positioned MoneyBuilder for a comfortable level of protection. As the price risk of widening margins is greatest in longer maturities, only gilts and the better-quality corporate bonds are held at the long end.

(MoneyBuilder is a specialised unit trust set up for investors wanting personal equity plans investing in corporate bonds. There are no front- end or exit charges, the running yield, excluding any capital gains when bonds mature, is currently 7.82 per cent, and the annual management charge is 0.7 per cent.)