Mark Atherton: Sorry, the love affair is over
Private investors have had a longstanding love affair with bonds — the
interest-bearing IOUs issued by companies and governments. In November they
bought a net £206 million of bond funds, beating the £196 million that they
put into equity funds.
However, many financial experts are questioning whether this continued
enthusiasm for bonds is justified.
Juliet Schooling, of Chelsea Financial Services, the independent financial
adviser (IFA), says that the strong demand for bonds has driven prices up
and yields down.
She says: “The result has been that yields on bond funds have been squeezed
down so far that the risk premium for holding bonds, rather than putting
your money in safer cash deposits, is now very small or nonexistent.”
With gross yields on bond funds now averaging about 4.75 per cent, there are a
number of savings accounts that pay higher rates of interest with no risk
and the latest interest rate rise will accelerate this trend.
Ms Schooling says: “Many private investors may well conclude that they are
better off in a high-interest deposit account where the capital value of
their money is not subject to fluctuations. In contrast, the capital value
of a bond fund investment is vulnerable to many things, such as higher
interest rates and the level of defaults among individual bonds.”
Charles Brand, of Principal Investment Management, another IFA, says that
bonds have done well for nearly a decade, but now look poor value when
compared with both cash and equities.
He asks: “Which asset does it make more sense to hold: a bond fund that offers
a modest yield and little prospect of capital growth or an equity fund that
is paying a slightly lower yield but has strong prospects of capital
growth?” Mr Brand highlights other factors that could cloud the prospects
for the bond market. Continued commodity price inflation could trigger
interest rate rises, which would, in turn, hit bond prices. Bonds would also
suffer if pension funds were to lose their apparently insatiable appetite
for them, while a sharp economic slowdown or recession would be particularly
bad news for the riskier high-yield bond funds.
Dan Kemp, of Williams de Broë, the stockbroker, says that it is especially
important in the current market to distinguish between different types of
bond fund.
Mr Kemp says that in the past investors would usually hold high-quality,
less-risky bonds in their portfolios and there would be little danger of
these bonds defaulting. But today bond funds have much greater exposure to
the riskier end of the market.
He adds: “It is vital that investors are aware of where their funds stand in
the overall spectrum because those at the riskier end of the market will
suffer disproportionately if there is a change in sentiment towards bonds.
“If investors want some bonds in their portfolio, we recommend that they go
for funds that will minimise their exposure to the high-risk end of the
market. One fund that would do this is the Cazenove Strategic Bond fund.”
Magnus Grimond: Investors will have to be more choosy
The bond market is a good place for contrarians right now.Such investors often
have difficulty knowing what the consensus is, so that they can do the
opposite. There is no such problem in the bond market.
This month’s rise in interest rates has cemented the view that rates have
further to go. When money costs more, that is generally bad news for
fixed-income securities, such as bonds, because their price should fall to
compensate.
Tim Bond, of Barclays Capital, the investment banking arm of the clearing
bank, says the real risk is that things are worse than the market has priced
in already and rates may rise even further. This makes most government
bonds, or gilts, unattractive, even those that pay back quickly and have
already factored in higher rates. “By and large, you are not going to lose
money buying two-year gilts, but they are not cheap — they are fairly
priced, at best,” he says.
But if the case for gilts is weak, there are still advocates for that recent
favourite of small investors: the corporate bond. Brian Dennehy, of Dennehy
Weller, the independent financial adviser, admits that mainstream corporate
bond funds “may have their work cut out to generate a margin over building
society rates”. But funds with wider remits and those with the new ability
to use futures and other derivatives under the European UCITS III directive
may prove better, he suggests.
It is early days for UCITS III funds, but Mr Dennehy says: “Strategic bond
funds with a roving brief, which take a bit more risk, have tended to
provide higher returns. And international bond funds may positively surprise
this year, if or when US rates start to fall.”
Robert Burdett, a fund-of-funds manager at Credit Suisse Asset Management,
says that the current environment for interest rates makes managers’ skills
particularly important. He agrees that funds able to take advantage of UCITS
III will have an edge, as will managers good at predicting future interest
rates.
James Gledhill, a bond fund manager at New Star Asset Management, is one who
believes that he can make a decent income return by using higher-risk bonds.
Large quantities of these high-yield bonds, once given the appellation of
“junk”, are often issued to finance takeovers of companies by private equity
firms. Yields can be in double figures, which means that the New Star Extra
High Yield Bond fund can offer investors about 6.75 per cent, after
expenses. The risks have risen recently, making him more cautious. Even so,
he notes that bond returns have been negative in only three of the past 26
years and the worst loss was only 6 per cent.
So income seekers may still find value in the bond market, but they will have
to be more selective than in the past.
The verdict
Overview: It is hard to argue in favour of bonds right nowl.
The risk-averse could do as well in cash. Risk-takers could try high -yield
and overseas bonds and funds using derivatives.
Experts' way in: Brian Dennehy, of Dennehy Weller, the IFA,
picks the Newton International Bond fund, while Robert Burdett, of Credit
Suisse, the fund management group, likes Gartmore Corporate Bond Fund.
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