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."