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August 31, 2012 5:02 pm

Warnings over corporate bonds boom

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Private investors are continuing to pour money into corporate bond funds amid the economic turmoil, but experts have warned that these investments are not as safe as many savers believe.

Fixed-income funds outsold all others for the eleventh consecutive month in July, with more than half of all investment last month going into the asset class, according to figures from the Investment Management Association.

Corporate bond funds remained the most popular sector, with investors ploughing almost £2bn into this asset class since the beginning of the year.

“With interest rates at record low levels, it is unsurprising that investors are chasing the higher yields on offer from corporate bonds,” said Jason Hollands of advisory firm Bestinvest.

Private investors have turned to corporate bond funds as they are deemed lower risk than equities, and typically offer higher income. However, experts warn that the sector is looking increasingly expensive and yields are falling.

“We’re towards the end of a 30-year bull market in bonds, so there are clear risks, particularly if you think you can sit in bond funds as a long-term holding,” said Brian Dennehy of Fundexpert.co.uk, an investor website.

Graph on Investment sector sales

Bond prices and yields move inversely, so as prices have edged up, yields have fallen and now range from about 2 per cent to over 9 per cent depending on where they are invested. But some of the best-regarded investment-grade funds – which invest in those bonds deemed least likely to default – now yield less than 4 per cent.

Dennehy believes liquidity is a key risk with corporate bond funds. “If there is another banking crisis, rolled up in the next episode of the euro crisis, it will hit bank bonds where some funds have heavy weightings,” he said. For example, Invesco Perpetual Corporate Bond fund has 38 per cent of its assets in bank bonds.

 
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“The next stage of this rolling crisis will make it even more difficult to sell bonds issued by banks and other financials, which can depress the fund values with heavy weightings,” said Dennehy.

The Financial Services Authority shares concerns over liquidity. Last month, the regulator wrote to corporate bond fund managers to ascertain whether they would be able to meet potential redemption demands.

Bond performance could also be hit by rising inflation on the back of further quantitative easing (QE) around the world. The Bank of England is already on its third instalment of QE and has left the door open for further easing of monetary policy in the autumn.

For this reason, advisers believe many savers are likely to be better off investing in equity income funds that offer capital and dividend growth.

“Dividend growth is one of the best ways to protect against inflation, something most bonds don’t do,” explained Tim Cockerill, head of collectives research at broker Rowan Dartington.

While equity income funds are deemed higher risk than bond funds, experts believe equity valuations look fair value while valuations have become stretched in some parts of the bond market.

“Dividend yields on UK stocks are well covered by earnings compared to historic levels, which suggests there may be some headroom for further increases,” noted Hollands.

As a result, for investors with a longer term horizon who can stomach greater volatility, equity income looks more attractive, according to Hollands.

Bestinvest recommends Artemis Income, yielding 4.6 per cent, and Blackrock UK Income at 4 per cent. However, Dennehy said investors need to make sure they invest in UK equity income funds which are increasing dividends; noting that as many as 34 per cent of UK equity income funds cut their payouts in 2011, including SWIP UK Income.

He believes Schroder Income and JOHCM UK Equity Income offer good value.

For investors who prefer to stick with bond funds, Dennehy recommends M&G Corporate Bond, Fidelity Moneybuilder Income and Henderson Sterling bond, which are underweight in bank bonds.

There’s also the option of strategic bond funds, which generally have more flexible mandates than plain-vanilla bond funds.

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