Corporate bonds: the only 'hot' story in town

Julian Knight reports on why the returns from firms needing to raise money could offer an antidote to meagre savings rates and turmoil on stock markets

Good news is thin on the ground for investors. Only brave hearts would look at getting back into the stock market at the moment, as it is still unclear whether we are headed for a worldwide recession or depression.

Meanwhile, British savers are living off scraps, as the Bank of England base rate was cut again last week to just 1.5 per cent. For savers it has been a quick transformation from feast to famine, with "best buy" account rates falling in the past three months from the 7 per cent mark to around 4 per cent.

Meanwhile, the hundreds of thousands of Britons who saw property as their passport to investment riches are licking their wounds as UK house prices have just had their worst year on record, plunging by more than 15 per cent. Commercial property has been a basket case for even longer, with many funds actually stopping investors from withdrawing their money.

So any area of investment that promises growth is going to spark more than a little interest. And it's the unglamorous world of corporate bonds that is catching the attention of those in the know. These bonds, it seems, are the one potentially "hot" investment of 2009. "They represent the opportunity of a generation, offering both capital growth and relatively high income," says Meera Patel, senior analyst at independent financial adviser (IFA) Hargreaves Lansdown.

Corporate bonds are a relatively simple concept. Firms needing to raise money issue bonds that promise to pay the buyer a fixed rate of interest, and at the end of the term the loan amount is repaid. Things do get more complex as there is a huge global market in the trading of bonds, but basically the rate that bonds pay is dependent on the underlying financial strength of the company issuing them.

Adrian Lowcock from IFA Bestinvest says: "You can divide firms issuing into three categories. You have the strong, well-funded ones – big names if you like – and then you have middle-tier companies, which have strength but may have some vulnerability to a downturn. Finally, you have riskier enterprises. The higher the risk of business failure, the higher the interest that has to be paid to get people to buy the bonds. It's a complex market, with analysts and rating agencies poring over the minutiae of the issuing firms, deciding who stands where."

But with the world economy speeding downwards, companies that were once thought ultra-safe are now being forced to offer higher returns to investors: "Bond rates are factoring in business failures and thereby defaults equivalent to or even worse than the great depression. So even big, well-funded firms are having to pay around 8 per cent interest a year to shift their bonds," says Ms Patel.

And firms that aren't in the top rank have to pay even more. "Rates around 10 per cent are now becoming common," says Mr Lowcock. "Set these against savings rates, shares and property prices and you can see why many people are getting excited."

However, he adds a note of caution: "We are likely to see a substantial number of business failures over the coming recession, though probably not as many as the markets are factoring into bond prices."

Chris Bowie, the head of credit at fund manager Ignis, agrees that the bond markets have overestimated business failures and therefore loan defaults: "During the worst five years of the 1930s depression, 5 per cent of bonds were defaulted upon. Even if that were to happen now, with current rates of between 8 and 10 per cent, investors would still get decent returns."

But he does have one reservation: "If the Government starts to print money to boost the economy, this could in the long term have an upwards effect on inflation, which could make the annual interest paid on bonds a bit less attractive."

Buying a fund, which invests in a large number of corporate bonds, is a way of spreading risk, Ms Patel points out. "There are a lot of good bond funds out there which do not have high initial charges. What's more, the funds can be held within an individual savings account, which means growth is tax-free."

Mr Lowcock recommends investors look at three funds in particular. "The Fidelity Moneybuilder invests in high- grade bonds from big companies but is currently paying 5.8 per cent a year even after fees. For people willing to take a touch more risk, the M&G Optimal Income fund is paying 6.95 per cent with no initial charge. The braver still could look at the Legal & General High Income fund, which is offering a return of 10.2 per cent."