Beware the jump into the junk yard

A little knowledge is dangerous for investors

A rash of new-style corporate bond funds spread across the market last year. The high-yield funds, which promise returns of up to nine per cent, were welcomed as the answer for investors struggling to maximise their investment income at a time of low interest rates.

A rash of new-style corporate bond funds spread across the market last year. The high-yield funds, which promise returns of up to nine per cent, were welcomed as the answer for investors struggling to maximise their investment income at a time of low interest rates.

But concerns have since grown that these high-yield corporate bond unit trusts are much riskier than they appear. But, according to the Association of Unit Trust and Investment Funds (AUTIF), gross sales of corporate bond unit trusts rose to £6.2bn last year from £3.7bn in 1998 - despite a fall in value over 12 months.

Like Government bonds, corporate bonds are basically interest-paying IOUs - issued by companies rather than the Government. While bonds are less risky than shares - they are higher in the pecking order if the company goes bust -- they are only as good as their issuer.

Bonds issued by well-established, blue-chip companies, are almost as safe as government bonds, but those issued by less financially solid companies can be risky in the extreme. Most corporate bond funds which describe themselves as "high-yield" hold a large proportion of their assets in sub-investment grade bonds - the infamous junk bonds of the 1980s.

Ratings agency Standard & Poor's assesses the creditworthiness of bond issuers. Its ratings range from AAA+ for the most financially solid concern down to D for default. A bond from an issuer with a rating above BBB - is considered investment grade, below this it is classed sub-investment grade.

Standard & Poor's says it is at this point that the incidence of the company defaulting on its bonds increases markedly. The daring new breed of high-yield corporate bond funds, has prompted AUTIF to split its UK General Bonds sector category of unit trusts from April. There will be UK Corporate Bond sector, which will include funds investing in investment-grade bonds, and UK Other Bond sector coveringfunds holding non-investment-grade paper.

"We began to realise that some funds were offering very high rates of interest and they weren't necessarily the same as funds with a conservative investment approach," explains Claire Arber of AUTIF. Providers of high-yield corporate bond funds include Perpetual, M&G and Gartmore.

Colin Jackson, of independent financial advisers Baronworth Investment Services, says corporate bond funds can be ideal for investors seeking a high level of income, but... "The problem is that people look only at the headline rate," he says. "What they don't realise is that the capital is not fixed and neither is the rate."

David Hanratty, of Nelson Money Managers, believes most people would be better off buying a selection of the underlying bonds instead. The charges for this would be far lower, he says.

"The advertisements stress the value of bonds, but by buying bonds in a collective investment you lose all the guarantees," says Mr Hanratty. The guarantee inherent in a bond that your capital will be returned at the end of the term only applies if the bond is not sold in the meantime.

He also sees a contradiction in the way these funds appear designed to attract the type of cautious investor who would normally save their money in a building society account, but in fact hold highly risky investments such as sub-investment grade bonds.

But a big attraction of a corporate bond fund is that it can be held within an Individual Savings Accounts, making the returns completely tax-free.

Schroders runs two corporate bond unit trusts, one high-yield fund and one which restricts itself to investment grade bonds. The high-yield fund is suitable for people looking for a high income, says Bernard Abrahamsen, director of fixed income at Schroders. "But I wouldn't regard it as a substitute for a bank or building society."

He says the investors are becoming attracted to corporate bond funds as they become more sophisticated and look for investments which diversify their equity holdings.

The corporate bond market is going to continue growing as fewer government bonds are issued, says Mr Abrahamsen. "One supportive factor is that government supply is quite low, so generally investors are looking to move down the credit curve," he says.

Nelson Money Managers: 01829 741331

Baronworth Investment Services, produces a free corporate bond survey: 0181 518 1218