Markets: Given time, you could learn to love bonds

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Bonds have never really won the hearts of British savers. It was hoped that the introduction of corporate bond Peps would change sentiment but nearly two years on, interest is waning.

The Government's anti- inflation drive has pushed down bond yields and returns so low that it's not surprising sales of corporate bond Peps have slumped in recent months.

But it may be too early to write off the experiment. By the end of the year, bond yields could start to look more attractive, and corporate bond PEPs may come back into vogue. Britons could learn to love bonds.

The Government launched its initiative in 1995, allowing savers to add corporate bonds into PEPs to persuade private investors to fund business investment. This would enable companies to raise cash without selling new shares.

To qualify for inclusion in a PEP, a bond must be issued by a UK company, pay a fixed interest rate and have at least five years left until it's due to be repaid. Bonds sold by banks or other financial institutions, or by the Government, aren't eligible.

Unlike our neighbours in Belgium or Italy, however, we continue to prefer stocks to bonds.

About pounds 2.5bn of new bonds which meet the criteria went on sale in the first quarter of the year, as companies such as Kingfisher, Dixons and Whitbread took advantage of corporate bonds' relative cheapness compared to gilts to stock up on easy funding.

But supply dwarfed demand. Investments in bond Peps have halved in the first two months of this year, compared with a year earlier.

Just pounds 67m was invested in January of this year, down from pounds 126m a year earlier. February's pounds 85m of new cash compares with pounds 164m a year earlier.

Last year Britons invested a net pounds 1.4bn in corporate bond PEPs, according to figures compiled by the Association of Unit Trusts and Investment Funds, the first full year the bond product has been available. That gives an average investment pace of about pounds 117m a month.

The typical buyers are older investors looking for a tax-efficient way to boost their retirement income. Buyers of equity PEPs, in contrast, are seeking capital growth.

Equity PEPs continue to grow in popularity, with net new investment worth almost pounds 530m in the first two months of this year, a 30 per cent jump from a year ago.

Investment in PEPs typically doubles in March and April as savers scramble to take advantage of the tax breaks available on PEPs before the end of the fiscal year.

Even if that pattern is repeated this year, there's little chance of March and April's corporate bond PEP sales matching the pounds 500m bought in the same two months last year.

Paul Minger, who manages corporate bond portfolios at Norwich Union, blames falling bond yields for the slump. His point is proved by Bloomberg studies which show 10-year corporate bond yields fell by as much as half a point in the second half of last year.

Returns on corporate debt have fallen ever closer to those available in the government bond market, making lower-rated corporate bonds expensive, compared with the underlying benchmark government securities.

In mid-1996, an investor could pick up 70 basis points of extra yield by buying a five-year bond from an "A"-rated UK corporate instead of a UK government bond. By the end of the year, that premium for buying the corporate bond had shrunk to 60 basis points.

Premiums on 10-year corporate bonds also narrowed relative to gilts, to 90 basis points at the end of 1996 from 80 six months earlier.

The overall returns on bond PEPs in the recent past have been a long way behind equity products. According to figures compiled by Micropal, which tracks investment fund performance, UK gilt and fixed interest unit trusts have returned 12.2 per cent in the past year.

That makes bonds the worst-performing of the six UK investment segments Micropal tracks, comprising balanced funds, smaller companies, general equities, equity growth and equity income. The five non-bond trusts had an average return of almost 17 per cent, with even the worst performer, smaller companies, beating bonds by more than 4 per cent.

Look over a longer period, and the under-performance of bond PEPs is worse. Gilt and fixed interest trusts returned 24.3 per cent in the past three years, compared with an average of 44 per cent for other trusts. Over five years, the 124 per cent made by the other trusts outstrips the 72.2 per cent return on the fixed income trusts.

The tide could be about to turn. This year, corporate bond premiums have started to rise, climbing to 73 basis points for a five-year bond and to 98 basis points for a 10-year bond. The prospect of higher official interest rates is pushing up the yield gap between corporate bonds and gilts.

Philip Crate, head of European credit research at French bank Paribas, for instance, reckons corporate bond spreads are likely to increase this year.

As the expected rate rise combines with over-supply in the market, corporate bonds should become cheaper relative to government debt, and yields should begin to rise. But there's no need to rush. Crate is recommending investors bide their time until the second half of the year. Copyright: IOS & Bloomberg