Look before you leap into the bond market

They may have a 'safe' image but bonds can still be risky, warns David Prosser

Corporate bond funds are supposed to be the medium-risk option for investors who want to move their cash out of the building society without all the risks associated with shares. But even medium-risk assets can sometimes turn out to be the wrong option for cautious investors.

Corporate bond funds are supposed to be the medium-risk option for investors who want to move their cash out of the building society without all the risks associated with shares. But even medium-risk assets can sometimes turn out to be the wrong option for cautious investors.

This is the dilemma for millions of investors who have just one more month to use this year's £7,000 individual savings account (Isa) investment allowance. Although the stock market has continued its slow recovery over recent weeks, many remain nervous about buying shares, following several years of disastrous returns. Research from fund manager New Star suggests that just one in 10 investors is prepared to consider buying stock-market-invested funds. Even residential property is a more popular option, despite persistent concerns that the housing market has slowed considerably.

Instead, many investors see funds that buy corporate bonds and other fixed-income assets as the best home for this year's Isa allowance.

"Investors are definitely leaning towards fixed-income funds," says New Star marketing director Rob Page. "This might seem surprising given the strong performance of equity markets, but investors are still drawn to the greater security of bonds."

But while bond funds have traditionally been regarded as a halfway house between cash and equities, the asset class could be much more risky than most investors realise.

In theory, because bondholders must be repaid before shareholders when companies begin to struggle, the sector as a whole should be more secure. But corporate bonds can still post disastrous returns, as investors in failing companies such as Enron have discovered to their cost.

Different corporate bond funds carry different risk characteristics. At the low-risk end of the scale, funds invested predominantly in gilts and other government bonds are the safest bet.

Blue-chip corporate bond funds, which invest in debt issued by large companies, are more risky, but should still be relatively secure. High-yield bond funds invest in less financially strong companies and are more volatile.

Some analysts believe now is the wrong time to be getting into any part of the sector. The latest Barclays Equity Gilt Study, one of the most widely respected pieces of investment research in the City, says bonds are a risky bet right now.

Author Tim Bond last week warned that high demand for bonds had lead to a serious reduction in the income that they pay in relation to their value. He now believes it will be difficult for investors to earn positive returns from bonds, even if they reinvest the income they receive.

Financial advisers are therefore wary. "The feeling among the product providers we talk to, even corporate bond fund managers, is that they favour equities over bonds right now," says Anna Bowes, head of investments at independent financial adviser Chase de Vere.

Patrick Connolly, a partner at independent financial adviser John Scott, is also concerned. "Most people are still sitting on their hands as far as the stock market is concerned," he says.

Even fund managers who are paid to promote corporate bond funds are currently pessimistic. New Star runs several large bond funds, but Rob Page warns: "At the gilts and investment-grade end of the market, bonds are susceptible to interest-rate risk and we are more cautious."

New Star's bond team is happier with investments in high-yielding bonds. But Page adds: "It's crucial to understand that corporate bond funds are not necessarily lower- risk than equities - it really depends on the type of bond that you buy and the economic environment."

That's not to rule out bond funds altogether. All investors need to build balanced portfolios of assets, with exposure to different types of investment based on their own attitude to risk and objectives. For income-seeking investors, as well as those who need to diversify out of equities, bond funds may still have value as a long-term holding, though they're not the only asset offering middle-of-the-road risk.

In other words, while investors are entitled to a new Isa allowance each year, entitling them to shelter £7,000 of investments from tax, it's important not to see each Isa as an unrelated purchase.

Financial advisers tip several funds in particular. Bowes recommends Old Mutual Corporate Bond as a good basic fund investing in blue-chip companies. Alternatively, she likes Threadneedle Asset Management's Strategic Bond fund, which invests in a blend of government bonds, blue chips and high-yield issues.

Alternatively, Connolly suggests Legal & General's Fixed Interest fund or Schroders Gilt & Fixed Interest.

"We prefer gilts and good-quality bonds right now, because high-yield bonds are moving too closely in line with equities," he says.

Another option is to look for a fund that specialises in identifying companies where finances are improving. All companies' bonds are evaluated by ratings agencies such as Standard & Poor's and given a measure of creditworthiness. If a company's rating improves, bondholders get a fillip.

Fidelity Investment says about 40 companies moved up to investment-grade ratings last year, immediately producing extra demand for their bonds. As the finances of companies such as BSkyB and Vivendi improved, the price of their bonds rose steadily.

Ian Spreadbury, Fidelity's senior fixed-income portfolio manager, says: "Thorough in-house analysis has enabled us to identify a number of those issuers prior to rating agency action and our portfolios have benefited accordingly."

The leading corporate bond funds returned around 10 per cent last year. But Fatima Luis, a bond fund manager at Foreign & Colonial, says performance is likely to be less attractive this year. "If you're expecting to see these kind of returns repeated, you're going to be disappointed."

ALTERNATIVES TO BONDS

Investors looking for a halfway house between cash and the stock market could opt for guaranteed equity bonds and funds. These offer exposure to the stock market but cap the losses investors can incur. In return, investors accept that they will not get the full upside of stock market gains when shares perform well.

Anna Bowes, of Chase de Vere, likes cautious managed funds and distribution funds. Gartmore Cautious Managed invests in a mix of assets, so that investors get exposure to high-return equities but have bonds to fall back on. Distribution funds are run similarly, but with investment limits in each asset class. Patrick Connolly, of John Scott, suggests funds that invest in commercial property. "One advantage of this asset class is that it has a very low correlation with other types of investment."

This means commercial property prices do not tend to fall at the same time as the value of other investments, which makes the sector a strong hedge.

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

News
The clocks go forward an hour at 1am on Sunday 30 March
news
Arts and Entertainment
The Doctor finds himself in a forest version of London in Doctor Who episode 'In the Forest of the Night'
TVReview: Is the Doctor ever going stop frowning? Apparently not.
Sport
footballMatch report: Real fight back to ruin Argentinian's debut
News
Bruce, left, with Cream bandmates Ginger Rogers, centre, and Eric Clapton in 1967
people
PROMOTED VIDEO
Money
Welcome to tinsel town: retailers such as Selfridges will be Santa's little helpers this Christmas, working hard to persuade shoppers to stock up on gifts
news
News
i100
News
people
Arts and Entertainment
Architect Frank Gehry is regarded by many as the most important architect of the modern era
arts + entsGehry has declared that 98 per cent of modern architecture is "s**t"
Arts and Entertainment
Soul singer Sam Smith cleared up at the Mobo awards this week
arts + entsSam Smith’s Mobo triumph is just the latest example of a trend
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

    Compensation and Benefits Manager - Brentwood - Circa £60,000

    £60000 per annum: Ashdown Group: Compensation and Benefits Manager - Compensat...

    Data Analyst/Planning and Performance – Surrey – Up to £35k

    £30000 - £35000 Per Annum plus excellent benefits: Clearwater People Solutions...

    IT Systems Business Analyst - Watford - £28k + bonus + benefits

    £24000 - £28000 per annum + bonus & benefits: Ashdown Group: IT Business Syste...

    Markit EDM (CADIS) Developer

    £50000 - £90000 per annum + benefits: Ampersand Consulting LLP: Markit EDM (CA...

    Day In a Page

    Wilko Johnson, now the bad news: musician splits with manager after police investigate assault claims

    Wilko Johnson, now the bad news

    Former Dr Feelgood splits with manager after police investigate assault claims
    Mark Udall: The Democrat Senator with a fight on his hands ahead of the US midterm elections

    Mark Udall: The Democrat Senator with a fight on his hands

    The Senator for Colorado is for gay rights, for abortion rights – and in the Republicans’ sights as they threaten to take control of the Senate next month
    New discoveries show more contact between far-flung prehistoric humans than had been thought

    New discoveries show more contact between far-flung prehistoric humans than had been thought

    Evidence found of contact between Easter Islanders and South America
    Cerys Matthews reveals how her uncle taped 150 interviews for a biography of Dylan Thomas

    Cerys Matthews on Dylan Thomas

    The singer reveals how her uncle taped 150 interviews for a biography of the famous Welsh poet
    DIY is not fun and we've finally realised this as a nation

    Homebase closures: 'DIY is not fun'

    Homebase has announced the closure of one in four of its stores. Nick Harding, who never did know his awl from his elbow, is glad to see the back of DIY
    The Battle of the Five Armies: Air New Zealand releases new Hobbit-inspired in-flight video

    Air New Zealand's wizard in-flight video

    The airline has released a new Hobbit-inspired clip dubbed "The most epic safety video ever made"
    Pumpkin spice is the flavour of the month - but can you stomach the sweetness?

    Pumpkin spice is the flavour of the month

    The combination of cinnamon, clove, nutmeg (and no actual pumpkin), now flavours everything from lattes to cream cheese in the US
    11 best sonic skincare brushes

    11 best sonic skincare brushes

    Forget the flannel - take skincare to the next level by using your favourite cleanser with a sonic facial brush
    Paul Scholes column: I'm not worried about Manchester United's defence - Chelsea test can be the making of Phil Jones and Marcos Rojo

    Paul Scholes column

    I'm not worried about Manchester United's defence - Chelsea test can be the making of Jones and Rojo
    Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

    Frank Warren: Boxing has its problems but in all my time I've never seen a crooked fight

    While other sports are stalked by corruption, we are an easy target for the critics
    Jamie Roberts exclusive interview: 'I'm a man of my word – I'll stay in Paris'

    Jamie Roberts: 'I'm a man of my word – I'll stay in Paris'

    Wales centre says he’s not coming home but is looking to establish himself at Racing Métro
    How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?

    A crime that reveals London's dark heart

    How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?
    Meet 'Porridge' and 'Vampire': Chinese state TV is offering advice for citizens picking a Western moniker

    Lost in translation: Western monikers

    Chinese state TV is offering advice for citizens picking a Western moniker. Simon Usborne, who met a 'Porridge' and a 'Vampire' while in China, can see the problem
    Handy hacks that make life easier: New book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone

    Handy hacks that make life easier

    New book reveals how to rid your email inbox of spam, protect your passwords and amplify your iPhone with a loo-roll
    KidZania lets children try their hands at being a firefighter, doctor or factory worker for the day

    KidZania: It's a small world

    The new 'educational entertainment experience' in London's Shepherd's Bush will allow children to try out the jobs that are usually undertaken by adults, including firefighter, doctor or factory worker