Mark Dampier: Corporate bond offers the chance of excellent returns

The Analyst

One of the big questions I am asked almost every day is "are corporate bonds a sell?" This is a natural question given the considerable capital growth seen since their low point in early 2009. Of course there is nothing wrong in taking a profit, but I disagree with commentators that argue there is little value left.

You don't need to be an investment genius to realise that the spectacular returns of 2009 are not going to be repeated. Yet there is still value in corporate bonds, particularly in those of financial companies such as banks, where the case for investing has been strengthened by recapitalisation and a return to profitability. However, my argument for continuing to hold corporate bonds is a little different and comes from looking at the economic scenario we face.

I believe the recession (which academics point out is technically over) is only about to begin for the consumer. The one-off boost given to mortgage-holders by the lowest interest rates for more than 300 years will wear off. Wage growth will be negligible, unemployment is likely to rise and we know income tax and VAT are going to increase.

Against this difficult background it is hard to see how highly-leveraged consumers can tolerate interest rates rising by much over the next few years. With public finances in a parlous state as well, the last thing the Bank of England wants to do is squeeze households further by raising interest rates.

So with the best instant-access cash accounts offering no more than about 2.5 per cent before tax, corporate bond funds yielding somewhere between 5 per cent and 7 per cent look a very reasonable buy – especially under the wrapper of an Individual Savings Accounts (Isa) or a Self-Invested Personal Pension (Sipp), which makes the income tax free.

So his week I thought I would focus on a corporate bond fund that I believe still offers the opportunity for excellent returns. The Invesco Perpetual team under Paul Read and Paul Causer has a long and successful track record managing bond funds, and their Monthly Income Plus Fund is a flagship of the range.

It is somewhat different to most corporate bond funds in that it allows the managers to invest up to 20 per cent in UK equities, which should give it greater potential for capital growth. This component is managed by Neil Woodford and, while his investment style has had a difficult 18 months or so, I believe it is just right for the situation we are going to be in for the next few years. His portfolio is full of large, strong companies with yields around or above 5 per cent, and they should continue to thrive even in a difficult economic climate.

I don't wish to dwell on the equity part too much because this is first and foremost a bond fund, and while there is still value to be found in corporate bonds I anticipate the greater part of returns will come from income rather than capital. Presently, Read and Causer feel that many of the best opportunities lie in higher-yield bonds. Their view (which I share) is that interest rates will remain low for several years. This offers the opportunity for investors in higher-yield bonds to receive an income significantly higher than cash.

Whilst a double-dip recession could cause a rise in companies defaulting on their bonds, I think this scenario is unlikely and we will probably see an environment of weak economic growth rather than a return to recession. Therefore, defaults ought to be limited if the managers are able to pick out companies that are resilient.

Clearly, this fund is not without risk with a heavy weighting of high-yield debt and exposure to the banks. I am sure too that concerns of sovereign debt will probably come back to haunt the bond markets over the next 18 months or so. However, much of this is probably already factored into prices. With interest rates staying low, I expect large inflows into what I believe are areas with compelling yields. With a portfolio managed by three of the most talented managers in the industry this fund represents a great way to exploit the mix of income opportunities that remain.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds included in this column, visit www.h-l.co.uk/independent

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

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