Beware when jumping on the bond-wagon
As returns from savings shrink, gilts and bonds look attractive, but high yields carry high risks, too.
Saturday 09 May 2009
Fund management house JP Morgan is the latest investment firm to jump on to the bond fund bandwagon. It launched its Strategic Bond Fund on Wednesday, and hopes to attract £200m-£300m-worth of investors' cash.
Fund manager Bob Michele says the fund hopes "to take advantage of the current situation. There are excellent opportunities in high-yield bonds and the securitised mortgage market in the UK and US.
"There are also a lot of opportunities in the bank and finance sector of the corporate bond market. There are valuations that we haven't seen in a lifetime of investing," he adds.
Michele has been a fund manager for around 25 years, most recently with Schroders and before that with Black Rock, so he does have a lot of experience in the fixed-interest market.
But is JP Morgan's launch this week simply hoping to cash in on the recent interest in bond funds?
There's little doubt that they have been the investment story of the last few months. Investors have piled into gilts – government bonds – and corporate bonds as returns from savings accounts have shrunk.
Such bonds are a halfway house between the safety of savings accounts and the risk of stock market investments. Gilts are issued by the government and corporate bonds by companies as a form of IOU. When you buy a bond you are effectively lending the issuer which it promises to pay back on a specified date. They normally last set periods such as five years and, in the meantime, pay interest.
The interest is known as the yield and for many is currently around 7 per cent, which looks very attractive compared to the best available rates on savings accounts, nearer 3.5 per cent at the moment.
But the risk is that the bond issuers will default, meaning you could lose all or part of your investment. The higher-yielding bonds – those which pay more interest – are more risky and more likely to default.
Of course, the same is true of any investment in the stock market; you run the risk of a company whose shares you have bought going bust. So, traditionally, investors would have added some bond funds to their portfolio to reduce risk and increase income.
In 2009 that's changed as the increasing volatility in the market has led to a flight to safety and many previously happy equity investors have turned to bond funds as a safer home for their cash. According to the Investment Management Association bond funds saw inflows of £1bn during March compared to just £445m for equity funds, for instance.
The appetite for bond funds has been high for months. But Bob Michele thinks there are still plenty of interesting investment opportunities – despite the ever-present risks of possible defaults.
"There are going to be a lot of defaults, so it's important to miss the ones that don't survive as well as pick the ones that do survive," he says. "Our fund is a best ideas global fund, which means we have the flexibility to invest in any market or sector including high yield debt and emerging markets." In other words, it means it can diversify away from British bonds, where there is currently greatest fear that companies won't meet their debt obligations.
Martin Bamford, joint managing director of financial planners Informed Choice, is cautious about investing in bonds, particularly given their recent popularity.
"Whenever a particular type of investment is 'in vogue' it always requires additional scrutiny," he suggests.
"Savers considering the move from cash to bonds should proceed with caution. Sadly, it is not as simple as comparing yields and opting for a top-performing fund."
Bamford says that about one half of corporate bond funds could be relying on default pricing methods which could in the long term lead to distorted valuations:
"The most common automated system for valuing underlying corporate bond fund assets is the iBoxx system but some managers are moving part of their portfolio away from this to use what they argue are more accurate manual pricing methods," he explains.
"This could result in some funds showing more favourable performance statistics than others, as they might be basing their statistics on unreasonable valuations."
Another consideration is the restrictions some funds place on holding bonds with different credit ratings, he says.
"When bonds are moved down the credit scale this can force funds to sell assets automatically, regardless of the future prospects of the bonds. This can make 'strategic' bond funds look more attractive than funds which simply invest in high-grade corporate bonds. Strategic bond funds have the flexibility to invest at different ends of the credit spectrum."
Bamford points out that what is currently making corporate bond funds in particular look attractive is the higher yield because of the increased risk of defaults. "There is a very real chance that we will witness a huge level of defaults in the coming months at the high-yield end of the market. The junk bond market in the UK has a relatively short history compared to the US, so this is all unchartered territory ."
Brian Dennehy, managing director of IFAs Dennehy Weller & Co, has been warning about the dangers of defaulting bonds for months. However, recent events have led him to temper his opinion.
"From 25 March when Lloyds, swiftly followed by RBS, offered to buy back their bonds from investors, the corporate bond market as a whole took on a new lease of life," he says. "After a torrid year for the great bulk of investment-grade bond funds – with marked exceptions such as M&G Corporate Bond – 25 March could turn out to be a very significant turning point."
Dennehy says the actions by Lloyds and RBS – and more recently by Barclays – gave a strong signal that the banking system may finally have begun to stabilise.
"Banking shares were already rising sharply, and though there must be doubt about the sustainability of this rally the same cannot be said of bank bonds if we assume they have now moved beyond the risk of formal nationalisation, and this is encouraging for the whole corporate bond sector," he says. He points out that from the beginning of the year until 25 March, only two out of 85 investment grade bond funds – both from M&G – made any money. From then until the end of April all but five of those 85 funds made money, some even in double digit percentages.
Dennehy's prediction now? "Bonds with higher proportions in banks and financials – which were the dogs of 2008 – are likely to outperform the rest of the sector for a while yet."
However, he still advises caution. "Despite the recent economic green shoots, and our natural optimism, risks remain and a blend of bond funds is sensible."
Which funds should you invest in? Dennehy says: "If you want income at a decent margin over the building society, aren't concerned about capital growth, and want the outstanding team of the last year or so, buy M&G Corporate Bond, which offers a gross yield of 4.8 per cent."
See the box top right where Richard Woolnough, the manager of the M&G Corporate Bond fund explains his investment philosophy.
"If you want higher income and the prospect of capital growth, consider Investec Monthly High Income. It offers 8.9 per cent gross yield and the potential for 30 per cent-odd of capital growth in the years just ahead, if they don't suffer too many defaults," says Dennehy.
And JP Morgan's new fund? Don't rush in, advises Dennehy. "My inclination with new funds is to wait and see how they perform. There are nearly always existing funds with similar remits and established track records."
Success story: M&G Corporate Bond Fund
While other bond funds were struggling this year, the M&G Corporate Bond Fund still made money. We asked Richard Woolnough, manager of the fund to explain the secret of his success.
"The main risk for bond investors is inflation. At the moment, we are in a low-inflation, low-interest-rate environment where we will remain for the next one to two years. We have argued for over a year that deflation is a very likely scenario for the global economy. It was announced on 21 April that the retail price index (RPI) was -0.4 per cent in the UK in the year to March, the first time that RPI inflation has been negative since March 1960.
The consumer price index (CPI), the Bank of England's favoured measure of inflation, also fell and is now back within the Bank's target range.
The other risk with investing in corporate bonds is default risk. As a bond investor you have to ask yourself 'Is this bond paying me enough for the risk that the issuer may default?'
Of course, there are many bonds that we won't buy at the moment because we think that the risks of the company going bankrupt are too great, and we are not being compensated for this risk.
We are therefore highly selective, and place a lot of emphasis on our in-house team of more than 50 credit analysts who rate and review each bond we invest in."
Debt in Britain: Numbers seeking help on how to cope with mounting bills goes up by more than half in three years
Bargain Hunter: BT improves its mobile reception with 'incredibly competitive' deals
Help to Buy Isa Q&A: Are they real help for first-time buyers or simply a vote-winner for the 2020 election?
Offset your mortgage and save thousands
Simon Read: 'It went below the radar but you could be eligible for a tax break on your savings'
- 1 Germanwings plane crash: Video shows co-pilot Andreas Lubitz learning to fly as a teenager
- 2 Germanwings crash: Captain of doomed plane was only 'on board because he changed job to spend more time with his children'
- 3 Ohio Democrat Teresa Fedor speaks out during abortion debate to reveal she has been raped – and is interrupted by laughter from Republicans
- 4 Germanwings plane crash: Transcript reveals passengers 'screamed for over five minutes' before plane crashed into mountain
- 5 Germanwings crash: 'Andreas Lubitz planned to marry pregnant girlfriend', claims German report
Ukip supporters are 55 or older, white and socially conservative, finds British Social Attitudes Report
JK Rowling responds to fan tweeting she 'can't see' Dumbledore being gay
Street preacher quoting from the Bible fined for calling homosexuality an 'abomination'
Jeremy Clarkson sacked live: Alan Yentob 'wouldn't rule out' ex Top Gear host's BBC return
Woman filmed launching racist tirade against men on the Tube for speaking in 'own lingo'
The West has it totally wrong on Lee Kuan Yew
iJobs Money & Business
£22000 per annum + pension,bonus,career progression: Ashdown Group: An establi...
£22000 per annum + pension,bonus,career progression: Ashdown Group: An establi...
£18000 - £20000 per annum: Recruitment Genius: A Client Services Assistant is ...
£25000 - £30000 per annum + benefits: Ashdown Group: A global leader operating...
Day In a Page
This four-bedroom cottage is a Grade II-listed town house, well-located for the thriving market town of Nailsworth.
A four-bedroom apartment on the ground floor of a stunning period property in North Yorkshire, with two kitchens and a large south-west facing garden.
This high-spec two-bedroom home is part of a smart collection of new flats at Beaufort Park and has a large decked balcony that's perfect for summer drinks.
Capitalise on the fabulous views of Trevone Bay by taking two homes and creating one spacious boutique B&B. Just a cliff-top walk from Padstow.
Overlooking a golf course, this six-bedroom Edwardian detached home spans four storeys and retains many period features including the original, operational servants' bells...
On the edge of the city, this six-bedroom home comes with an outdoor swimming pool and a large garage block that has annexe potential.
In a Grade II-listed manor just outside of Bath, this three-bedroom home is arranged on two floors with a skylight in a vaulted roof line.
Open the living room's bi-fold wooden doors to reveal a retro-style kitchen, and a conservatory leading to a paved garden at this three-bedroom home.
A Grade II-listed, four-bedroom home, in a charming Somerset village, with a two-storey studio that could be converted into a holiday cottage
A modern four-bedroom Victorian home, within walking distance to the high street
A luxury apartment in the Gothic mansion of Wyfold Court in Kingwood, offers six bedrooms spread over three floors and a turret
This school conversion, near Stockwell Tube, oozes New York loft style. The one-bedroom flat features double height ceilings and exposed brick work
This six-bedroom Georgian home is on three floors with open fireplaces, a two-oven Aga, an annexe, and cottage gardens with outbuildings and a car barn
High Crest House covers an impressive 9384sq ft, with almost three acres of grounds including a tennis court and summer house enclosed by electric gates
A six-bedroom farmhouse with separate accommodation in converted stables. Situated in the village of Church Aston, within walking distance to the market town
A two-bedroom flat with under-heated walnut floors and bespoke built-in storage. The Tube and Clapham Common are a short stroll away
A refurbished seven-bedroom townhouse with staff quarters, cinema room, superb gym, steam room and plunge pool
A minimnalist four-bedroom home designed to the highest spec, featuring glass walls and a kitchen space lit by a glass roof
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park
A state-of-the-art farm-building conversion on the former Cliveden Estate, with 11,420sq ft of internal space, cinema and wine cellar
Windsor Castle overlooks this three-bedroom Victorian cottage located on one of Windsor's smartest roads
A boutique mews house, set around a central courtyard, with three bedrooms and a private roof terrace
A four-bedroom farm-conversion with three bathrooms and two reception rooms
A two-bedroom detached house with ensuite bathrooms and a sun-drenched decked terrace, £750,000
A modern and spacious two-bedroom, penthouse flat with two bathrooms in a prestigious development
A beautifully renovated five-bedroom terrace with three reception rooms and a courtyard garden, £700,000
A four-bedroom period house which has been extended to provide almost 2,500sq ft of living space, £675,000
A pretty three-bedroom Georgian home with a 22ft drawing room and a master suite with a balcony, £525,000
A substanstial family home with five bedrooms and landscaped gardens in the much sought-after Branksome Park area
A well-presented three-bedroom house with front and rear gardens, close to White City station, £475,000
A handsome five-bedroom house in a sought-after location close to the city centre
A five-bedroom country home with valley views, equestrian stables and 27 acres of land, £725,000
A six-bedroom farm house with separate, detached cottages and 371 acres of land
A two-bedroom cottage with parquet floors, chunky beams and an open fireplace
A three-bedrrom flat with 2,733sq feet of living space, a beautiful private garden and 15 acres of communal grounds
A four-bedroom chalet bungalow with three bathrooms and a spacious garden, £525,000
A two-bedroom flat with an open plan kitchen and two balconies, close to Arsenal station