Beware when jumping on the bond-wagon

As returns from savings shrink, gilts and bonds look attractive, but high yields carry high risks, too.

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."

Independent Partners; request a free guide on NISAs from Hargreaves Lansdown

PROMOTED VIDEO
Life and Style
tech
News
The 67P/CG comet as seen from the Philae lander
scienceThe most important scientific breakthroughs of 2014
Arts and Entertainment
Ian McKellen as Gandalf in The Hobbit: The Battle Of The Five Armies
film
Arts and Entertainment
Sarah Koenig, creator of popular podcast Serial, which is to be broadcast by the BBC
tvReview: The secret to the programme's success is that it allows its audience to play detective
News
Ruby Wax has previously written about her mental health problems in her book Sane New World
people
Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Ashdown Group: Marketing Services Manager - (communications, testing, DM)

    £32000 - £35000 per annum + benefits: Ashdown Group: Marketing Services Manage...

    Guru Careers: Finance Account Manager

    £Neg. (DOE) + Excellent Benefits: Guru Careers: A Finance Account Manager with...

    Ashdown Group: Java Developer - Hertfordshire - £47,000 + bonus + benefits

    £40000 - £470000 per annum + bonus: Ashdown Group: Java Developer / J2EE Devel...

    Ashdown Group: Direct Marketing Manager - B2C, Financial Services - Slough

    £45000 - £55000 per annum + Benefits: Ashdown Group: An exciting opportunity h...

    Day In a Page

    Homeless Veterans appeal: 'You look for someone who's an inspiration and try to be like them'

    Homeless Veterans appeal

    In 2010, Sgt Gary Jamieson stepped on an IED in Afghanistan and lost his legs and an arm. He reveals what, and who, helped him to make a remarkable recovery
    Could cannabis oil reverse the effects of cancer?

    Could cannabis oil reverse effects of cancer?

    As a film following six patients receiving the controversial treatment is released, Kate Hilpern uncovers a very slippery issue
    The Interview movie review: You can't see Seth Rogen and James Franco's Kim Jong Un assassination film, but you can read about it here

    The Interview movie review

    You can't see Seth Rogen and James Franco's Kim Jong Un assassination film, but you can read about it here
    Serial mania has propelled podcasts into the cultural mainstream

    How podcasts became mainstream

    People have consumed gripping armchair investigation Serial with a relish typically reserved for box-set binges
    Jesus Christ has become an unlikely pin-up for hipster marketing companies

    Jesus Christ has become an unlikely pin-up

    Kevin Lee Light, aka "Jesus", is the newest client of creative agency Mother while rival agency Anomaly has launched Sexy Jesus, depicting the Messiah in a series of Athena-style poses
    Rosetta space mission voted most important scientific breakthrough of 2014

    A memorable year for science – if not for mice

    The most important scientific breakthroughs of 2014
    Christmas cocktails to make you merry: From eggnog to Brown Betty and Rum Bumpo

    Christmas cocktails to make you merry

    Mulled wine is an essential seasonal treat. But now drinkers are rediscovering other traditional festive tipples. Angela Clutton raises a glass to Christmas cocktails
    5 best activity trackers

    Fitness technology: 5 best activity trackers

    Up the ante in your regimen and change the habits of a lifetime with this wearable tech
    Paul Scholes column: It's a little-known fact, but I have played one of the seven dwarves

    Paul Scholes column

    It's a little-known fact, but I have played one of the seven dwarves
    Fifa's travelling circus once again steals limelight from real stars

    Fifa's travelling circus once again steals limelight from real stars

    Club World Cup kicked into the long grass by the continued farce surrounding Blatter, Garcia, Russia and Qatar
    Frank Warren column: 2014 – boxing is back and winning new fans

    Frank Warren: Boxing is back and winning new fans

    2014 proves it's now one of sport's biggest hitters again
    Jeb Bush vs Hillary Clinton: The power dynamics of the two first families

    Jeb Bush vs Hillary Clinton

    Karen Tumulty explores the power dynamics of the two first families
    Stockholm is rivalling Silicon Valley with a hotbed of technology start-ups

    Stockholm is rivalling Silicon Valley

    The Swedish capital is home to two of the most popular video games in the world, as well as thousands of technology start-ups worth hundreds of millions of pounds – and it's all happened since 2009
    Did Japanese workers really get their symbols mixed up and display Santa on a crucifix?

    Crucified Santa: Urban myth refuses to die

    The story goes that Japanese store workers created a life-size effigy of a smiling "Father Kurisumasu" attached to a facsimile of Our Lord's final instrument of torture
    Jennifer Saunders and Kate Moss join David Walliams on set for TV adaptation of The Boy in the Dress

    The Boy in the Dress: On set with the stars

    Walliams' story about a boy who goes to school in a dress will be shown this Christmas