Diverse appeal of corporate bonds

Inflation fears dampen the appeal of corporate bond funds as investors anticipate a fall in returns, but the maturing sector offers choice and stability to a portfolio in volatile times.

From being the favourite sector for advisers, investors have been deserting corporate bond funds in their droves. It is not hard to see why. The sovereign debt crisis that has plagued Europe generated a welter of adverse commentary – and inflation is re-emerging as a threat. With a rising cost of living investors might expect higher interest rates. And dearer money means higher bond yields, so prices would have to fall.

True, it has not happened yet in any meaningful way, but the nervousness in this sector of the market is apparent. And given the useful profits that have been generated over the past couple of years, who can blame investors for locking away some of their gains? But these funds do have one advantage in an investment environment that remains volatile. With equity income under pressure as dividends are reduced or abandoned altogether, where else can a reliable income be secured at a time when bank deposits yield next to nothing.

”The number of funds has mushroomed and the amount of research devoted to bond and credit markets is considerable”

Corporate bonds are expected to perform in a way that more reflects the level of interest rates than what is happening in the wider economy. But in 2008, when Lehman Brothers collapsed, this sector of the market was punished as severely as equities. At one stage even investment grade bonds were priced to suggest a huge failure rate. The subsequent recovery generated equity-style returns for bond investors and persuaded some that this was the coming sector.

It has matured as a market for private investor funds. Once the province of the professional, institutional in­vestor, the number of funds has mushroomed and the amount of research devoted to bond and credit markets is considerable. The growth of the rating agencies – and the increasing power they wield – has also focused attention on what, for the retail investor at least, was once a relative backwater. Bond and debt markets dwarf those of ordinary shares, though, so in many ways this increased coverage is no more than deserved. (article continues below)

And with this increased interest has come a variety of approaches to the business of managing bond portfolios. When this sector was last examined in 2009, changes were highlighted, with the Investment Management Association having just reorganised the sub sectors into which funds were grouped. In part this reflected the differing approaches being taken, with the then new Strategic Bond sector allowing a wider choice of securities to be included in those funds. However, it was also necessary to clarify the different characteristics of the bonds available.

Sterling Corporate Bonds is still considered the core sector for private investors seeking a fixed interest component to their portfolios. With more than 90 funds, the choice is wide. But performance varies, with the five-year tables recording a 25% rise for the best performing fund and a 13% fall for the worst. And the tail-end Charlie comes from an investment house with a solid reputation in fixed income – Axa.

What is also interesting is that the stars of August 2009 are not necessarily those of January 2011. M&G, which featured strongly then in all time-frames reviewed, has slipped. While its strong earlier performance keeps both funds in the five-year tables, the Corporate Bond fund fell to third quartile over one year and fourth for six months. Their Strategic Corporate Bond fund fared a little better, sticking in the second quartile over six months and a year, allowing it to remain in both the three-year and five-year top five.

The five-year charts on this occasion demonstrate just how much progress this sector has made. The top performing fund a year and a half ago delivered a return of 18.5%. This time the best performer -M&G’s Strategic Corporate Bond fund – rewarded investors with a 40% plus gain. Returns of this nature can only be delivered when the market is on your side, which with interest rates coming down it was.

So the important judgment is whether a tightening of monetary policy to curb the inflation threat will be as damaging for bond investors as many fear. In this country all the signs point to a rise in rates once the authorities are convinced that the economic recovery is robust enough to shrug aside dearer money. Overseas the picture is less clear. China has already introduced measures to try to calm inflation, while in America there is little sign of real cost of living pressures.

For the domestic investor and adviser, the Sterling Corporate Bond sector will doubtless continue to occupy a key role in portfolio construction where income is an important consideration.

For those investors who moved into such funds as interest rates fell and equities looked increasingly risky, the easy money has been made. Some shift in sentiment is likely if interest rates start to rise, but there is likely to be continuing support for a sector which should enjoy less volatile characteristics from a range of investors.