The Analyst: Bounce-back beckons bond buyers

Several weeks ago in this column, my colleague Mark Dampier mentioned the opportunities available in corporate bonds. Like every other asset class, bonds have suffered as a result of the credit crunch. In fact, there have been double digit falls in many bond funds over recent months as investors become increasingly nervous about company solvency. This is especially painful for what has traditionally been considered a lower risk investment.

One massive factor affecting the corporate bond market is financial companies. Around 55 per cent of the investment-grade bond market is made up of financial companies, such as banks and insurance companies. With the economic turmoil over the past 12 months, and many banks seemingly under threat, it's no wonder that bond prices have been hit as well.

I recently met with James Gledhill, manager of the New Star High Yield Bond Fund, to get his views on the bond market as a whole. His first comments were that he believes the government's plan to recapitalise the banks will actually make a difference. In Gledhill's opinion, the plan addresses the key problem facing banks; not liquidity as is often reported, but in fact solvency. Solvency refers to the ability to actually pay off one's debt, whereas liquidity refers to the everyday lending between one bank and another, which is the oil that keeps the financial system running smoothly.

The vast quantities of money already pumped into international money markets by central banks should solve the liquidity problem. However, banks have been hoarding cash because they are worried about lending money to other institutions; they have realised that nobody is too big to go bust. The recapitalisation plan being put into place across the world should sort this out in the long run, because governments will be major shareholders in the most-troubled institutions.

To put Gledhill's views on banking bonds into context, he mentioned that both Santander and Royal Bank of Scotland now both have bonds trading at effectively half price, ie they are valued at 50p when they should eventually redeem at £1. Contrary to the generally perceived view, Gledhill does not see concerns over defaults as the prime reason for these astonishing price falls. His view is that the bonds are trading at such low prices because there has been huge oversupply at a time when there is little or no demand for bank debt. He does, however, believe that the plumbing of the banking system is gradually unblocking, and if a measure of confidence can be restored then demand should pick up.

The New Star High Yield Bond fund is approximately 60 per cent exposed to higher yielding, more risky bonds with the remainder invested in higher quality investment-grade bonds. There is a big financials weighting in the fund. This has harmed performance this year, but for those buying today most of the bad news should already be factored into the price.

Gledhill thinks the higher yielding part of the portfolio is in pretty reasonable shape, mainly as there has been very little issuance of new bonds in this area over the past few years; so it has not been burdened by oversupply. The average price of high yield bonds is approximately 77p in the pound, with average yields at an eye-catching 16 per cent. This means that, on average, a fifth of bonds could default and investors could still break even. To put this in context, the previous highest default rate was 10 per cent during the 1991-1992 recession with a peak of 10 per cent. Market prices are currently predicting a default rate of 25 per cent. Will this happen? I'm afraid nobody knows for sure.

New Star has had a lot of problems over the past few years, but the bond team remains one of the bright spots, despite recent performance. This fund is currently yielding almost 9 per cent with a gross redemption yield of over 11 per cent. Long-term investors in search of income might consider an investment in the sector, but only those prepared to take risks should actually take the plunge.

Ben Yearsley is an investment manager at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For further information about the funds that are mentioned in this column, visit www.h-l.co.uk/independent.