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Once-safe bonds market faces an uncertain outlook

Rising interest rates have already hurt private investors, says Iain Morse

Saturday 26 June 2004 00:00 BST
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For as long as many of us can remember bonds have been going up in value and investors have thrown buckets of our money into them. The perfect antidote to falling equity markets, gilts and corporate bonds have been favoured by falling inflation and falling interest rates for several years.

"Now that has changed," says James Gledhill, the fixed income fund manager at New Star. "Conditions started going negative 18 months ago, particularly for gilts, and it is hard to see that they will improve for some time yet."

Rising interest rates have already hurt private investors. As interest rates are predicted to rise to 5 per cent this year and to as much as 5.50 per cent by the end of next year, a lot of medium-to-long-dated bonds bought when rates were below 4 per cent have suddenly started to look expensive.

The relationship between bond prices and bank interest rates is brutally simple. The total return on a bond is the interest paid out plus its original issue price. This sum must be discounted by an assumed future rate of inflation to present-day values. That net amount is the real return on the bond. The aim is to buy the bond for less than this amount.

From the investor's point of view, two types of risk are involved in buying a bond.

Interest-rate risk refers to a change in interest rates that increases or reduces the bond's real return. Secondly, there is default risk, that the issuer will fail to meet some or all their repayments.

"When you buy or sell a bond you do so with a particular set of rate and inflation expectations," says John Patullo, who manages several retail bond funds for Henderson Investors.

"If expectations change, particularly if interest and inflation expectations go up, then the value of a bond will usually fall." So when you read that bond yields are rising in response to an interest-rate increase this is bad news for the bondholders.

"In effect, the market is saying that the expected real value of the total return on those bonds has fallen," says Mr Patullo, "so buying that return becomes cheaper."

The impact of a 1 per cent interest-rate rise on a medium-dated bond paying 7 per cent will be around a 10 per cent fall in the bond's price.

But that is not all. Default risk rises and falls according to the state of the economy and interest rates. Some companies do well when rates rise, and some run into difficulties.

"We tend to think of stock-picking as a concept mainly applicable to shares," says Mr Gledhill, "but it applies just as much to bonds, particularly as you move from high to lower quality."

And unique, unpredictable events can also have a huge impact on bond values. Take the current takeover bid for Marks & Spencer.

M&S issued 10-year bonds in March, before the bid, on a coupon of 5.625 per cent. After Philip Green said he might bid, markets drove these bond prices down until they offered a yield of over 8 per cent, which has now fallen back to around 7.5 per cent as the price has recovered a little.

So just when we thought bonds were safer than equities, the markets have delivered a different judgement. And there is worse to come.

"These days the US Federal Reserve is really decisive in setting the value of money and bonds," says Mr Patullo, "and, with inflation re-emerging in the US, rates there may have to climb higher than expected."

US money has been so cheap, with rates at just 1 per cent, that experts regard some price inflation as inevitable. "Too much cheap money for far too long," says Mr Gledhill, "too much borrowing, too much consumer spending. It all has to be paid for."

The US and UK economies and markets are highly correlated, and both have relatively liquid bond markets.

Remember that, unlike shares, bonds are traded over the counter, prices set per deal. In some countries, such as Switzerland, many bonds are held to maturity. But they are actively trading in the UK and that exposes them to competitive market pricing. Arbitrage, trading by hedge funds between the US and UK markets, makes sterling-denominated bonds very vulnerable to any change in the US. What goes up together, goes down as well.

"If the US gets higher inflation and raises their rates more than expected, then the outcome cannot be positive for UK bonds," says Mr Gledhill. "This amplifies risk."

All this sounds depressing for bondholders, but not everyone is quite so pessimistic. "We think rates will peak at 5.25 per cent," says Alex Stewart, fixed-interest manager at Gartmore Investment Management, "and much if not all the bad news is priced into the market already." Fund managers and stockbrokers are adjusting their portfolios to make them more defensive, because the impact of higher interest rates and inflation is unevenly reflected in bond values.

The bond universe is split into quality grades or levels. Rating agencies, notably Standard & Poor's and Moody's, sell rating information to investors. Credit events, bond upgrades or downgrades, always affect bond prices. As a rule of thumb, the highest-quality bonds are more exposed to interest-rate risk, the lowest to default risk. Bonds in the first group are termed investment grade, in the second, sub investment, high yield or even junk bonds.

Gilts issued by the UK Treasury are regarded as free of default risk, against which all others are measured.

This is done by comparing the difference between the yield to maturity on a corporate bond and on comparable gilts, and is always expressed as a number of basis points, or hundredths of a per cent.

Just below gilts sit high-quality investment grade bonds issued by banks and very large multinationals.

Banks, in particular, tend to be highly regulated, obliged to meet stringent capital adequacy regulations and are therefore very creditworthy.

HBOS has a bond maturing on 21 December 2007, paying 44 basis points, or just under half of 1 per cent, more than a comparable gilt. And Barclays Bank bonds, maturing 12 months earlier, are only 25 basis points higher.

Move down to lower-quality investment grade bonds and spreads open up dramatically. Bonds maturing in 2018 issued by Enterprise Inns, rated BBB by S&P's, trade on a spread of 161 basis points.

And bonds issued by Investec Finance to mature in 2016 are on a spread of 268 points, or 2.68 per cent, in part because they are so long-dated, in part because Investec is only rated as a Baa3 by Moody's.

Expect high-yield, sub-investment grade bonds to trade on a spread of around 375 points and triple C's on as much as 740 points or 7.4 per cent. In these spreads lies some consolation for bond investors. "We are shortening duration and diversifying client portfolios," says the private client stockbroker Peter Smart of Brewin Dolphin Securities.

Rising interest rates are an indicator of economic recovery. Pick the right bond, in a company benefiting from recovery, and you still might find a combination of high yield and capital gains.

"If you are invested in a pooled fund, check what type it is and what freedom the manager has to adjust his portfolio in the face of changing market conditions," says Mr Smart.

Brewin Dolphin has gone further than many fund managers are permitted by their mandates.

"We take account of client attitudes to risk but in general I would advocate a 70/30 split between investment and high yield bonds," says Mr Smart. "You can even have exposure to emerging market debt hedged back into sterling."

For risk averse investors cash is likely to be a favoured alternative to bonds. With bank base rates at 4.25 per cent and set to climb higher, interest on deposit accounts is getting closer and closer to the yields offered by medium-length dated gilts.

The million-dollar difference between the two is that while bank deposits cannot fall in value gilts can and have done.

"The decision on which to hold must now be pretty finely balanced for most savers," says Mr Patullo. The tactical advantage offered by cash is flexibility. An instant access account from Birmingham Midshires, the Telephone Plus (Issue 2), is paying a gross flat rate of 4.7 per cent on all deposits, including a 0.85 per cent annual bonus.

Scarborough building society has a Scarborough 99 day account which pays 5 per cent gross, including a 0.75 per cent on accounts held for at least six months.

Meanwhile, one of the best monthly interest account comes from Chelsea building society, paying a flat rate 4.65 per cent on its Guarantee 80 account. And check out some of the new, tax-free, mini-cash Isas. Portman building society is offering a compound return of 5.50 per cent a year over 5 years.

But if you want a simple no-frills, instant-access account, the best is still ING, now paying 4.9 per cent.

'I think that the best years are over'

"I started switching into corporate bonds three years ago when equity markets fell," says Callum Buchanan, who runs the Merz Art Gallery in Edinburgh's Broughton Street, "because I liked the combination of fixed income and some capital growth which they offer."

Dealing in a wide range of modern art, from Tracey Emin to Howard Hodgkin, as well as fresh college graduates, Mr Buchanan reckons he will never retire. "I can't imagine wanting to, and anyway may never be able to afford it. The idea behind buying bonds is to give me an income supplement so I can afford to work a bit less."

Even so, he is thinking of switching at least half his portfolio into equity income funds. "My gut feeling is that bonds have a couple of good years, but that is over. If you believe the economy is going to grow then equities must outperform in the longer term."

FACT FILE BUYING GILTS AND BONDS

* If you decide to buy gilts and feel you don't need advice start with the Bank of England's Brokerage Service, which always has a stock of unsold gilts with varying coupon rates and maturity dates. The charges are very competitive. For sales or purchases worth less than £5,000 it charges 0.7 per cent commission, minimum £12.50. Over £5,000, it's a flat £35 plus 0.375 per cent of the deal value.

* Stockbrokers such as Brewin Dolphin offer both advisory and discretionary management of client bond portfolios. Advisory means they will give advice, discretionary means they will manage a portfolio without consulting the client. Brewin's research covers a wide range of gilts and corporate bonds. Its advisory fee is 1.95 per cent of the first £12,500 of a transaction, 0.70 per cent of the next £12,500 and 0.50 per cent thereafter. The discretionary fee is 1.20 per cent on the first £12,500.

* There is a wide choice of bond funds to choose from. They can be bought into through financial advisers, or sometimes through a direct approach to the fund manager. There are four broad categories:

UK Corporate Bonds is by far the largest group, with 113 funds. These vary hugely in size. One of the smallest, Abbey National's Multi Manager Monthly Accumulation, has a fund value of just £5.7m. The largest, Scottish Widow's, has around £1.9bn under management. Funds in this sector must have at least 80 per cent of their value in investment grade sterling- denominated bonds.

* The next sector, UK Gilts, has funds with at least 90 per cent invested in UK government securities. All the 39 funds in this sector have lost value due to interest rate rises. Average fund size is smaller than Corporate Bonds, with the largest, First State's, worth £250m.

* Thirdly, UK Index Linked Gilts, a far smaller sector with just 12 funds, each of which must be 90 per cent invested in index-linked gilts. These are gilts where the interest rate is adjusted to take account of inflation. This sector has risen in value under the impact of rising interest rates and increasing expectations of a new round of inflation, here and in the US. Fund sizes are small. The largest, Fidelity's, has a value of £200m. Several of these funds can be accessed only through personal pensions.

* UK Other Bonds is a category of growing importance because its 57 constituent funds must invest at least 20 per cent and up to 100 per cent of their value in high-yield bonds. These offer income yields of up to 8 per cent and have survived remarkably well under the impact of rising interest rates, which are a signal that the issuing companies are in a buoyant, fast-growing economy.

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