Corporate bonds: Don't be a fund fashion victim

Corporate bonds: Don't be a fund fashion victim
Bond funds are in vogue – they were the best selling funds last month by a mile. But that might just set the alarm bells ringing...

By Paul Farrow
Last Updated: 6:13PM GMT 18 Feb 2009

Following fashion when it comes to choosing funds can be an expensive mistake.
You could be forgiven for thinking that we have all given up on investing given the torrid performance of shares and bonds over the past year.

But there are early signs that investors' confidence is returning – the latest figures from the Investment Management Association showed that more than £1.5bn was invested in December, a traditionally poor month, for obvious festive reasons.

It could be that investors feel, with significant losses already racked up, that there are opportunities beginning to open up. Or it could be that with returns on cash at pitifully low levels they need to take on a little more risk in a bid to get any sort of return on their money.

Bond funds are in vogue – they were the most popular funds last month by a mile – and that might just set the alarm bells ringing.

The nature of investment – fund groups want to rake in assets, financial advisers want to sell funds and investors want to make gains – means that fads and fashions become inevitable. The most fashionable fund type each year tends to come down with a mighty bump the following year.

Every year certain types of fund reign supreme. We saw it in the technology boom in early 2000 when millions of pounds were invested in technology funds such as Henderson Global Technology at the top of the market. The bubble burst and people were left nursing huge losses.

In 2006 the commercial property phenomenon provided us with another classic example of investors following a fashion. Tens of thousands of them jumped onto the bandwagon (Norwich Union's fund proved extremely popular) just as the market scaled new heights. But those who joined the party late hoping to make a quick buck will have lost as much as 50pc of their money.

The only time it would have paid to be fashionable was in 2003 when everyone rushed to get a piece of the gold action as markets sank to a new low. Those who bought into gold via the BlackRock Gold & General fund have seen the value of their investment rise by 150pc since.

Peter Jordan of Skandia said: "If you blindly follow the themes and fashions you will get a rougher ride – you should stick to asset allocation based on your attitude to risk. Fund picking is a hazardous activity and if people have been burnt by market volatility and are worried what further impact low inflation will have then they need review the asset allocation within their portfolio."

Corporate bond funds are the new black because they offer lower volatility and a decent yield – attractive selling points amid the turmoil and dire rates of interests. They are also deemed an appropriate investment during times of falling inflation. "Corporate bond funds litter the top 10 funds this year," said Mr Jordan.

Many experts continue to believe that corporate bond funds investing in high quality bonds are a decent bet for this year. The arguments in favour of bonds are strong. Corporate bond markets typically recover before equities after times of economic woe. Bond prices are pricing in default rates of 35-40pc – yet, looking back over the years, the worst default rate for investment grade bonds was 2.4pc. Some bonds are yielding upwards of 8pc and a small narrowing of spreads will double the return. (Comment: Barclay's Bank bond)

Unlike with previous fads, investors aren't piling into bond fund because they have made stupendous gains. "This popularity is not based on good past performance but rather on the poor performance of these funds over the past six months," said Jason Walker of AWD Chase de Vere.

The case for investment grade corporate bond funds looks compelling and is worth considering but the bond story is not a no-brainer. The market is illiquid and some bond managers are stuck with poorly performing bonds they cannot sell. What's more, a surge of gilt issuance by our cash-strapped Government means there will be no shortage of stocks for buyers to choose from.

Mark Piper of Collins Stewart said: "There has been a huge increase in the number of investment articles highlighting the opportunities in corporate bonds in recent weeks. While the valuations are not quite as eye-catching as they were in October and November last year, high quality investment grade corporate bonds are still extremely attractive in our opinion, particularly when compared to government bonds and cash deposits."

He added: "The rush for corporate bonds could have all the hallmarks of an early stage mania but as long as you're focusing on senior investment grade debt then the values is real. Our favoured ways of accessing this asset class are via the M&G Corporate Bond fund and Invesco Sterling Bond fund."

Richard Woolnough, a fund manager at M&G, argues that investors who buy bonds now are locking into a high fixed rate of interest, which will be "extremely" attractive as the Bank of England's interest rate heads toward zero.

"With investment grade corporate bond yields now hovering around all-time high levels, the market is effectively saying that about 40pc of all investment grade bonds will default over the next five years, assuming average historical recovery rates. This view is far too pessimistic, which means that investors are being hugely overcompensated for the actual risk of default."

But not everyone is convinced. Gary Potter, a multi manager at investment boutique Thames River, says: "Everyone is piling into corporate bonds and I'm very concerned. They pay a decent coupon, but no one knows how big a hole we are in. There could yet be liquidity issues with bonds and what happens if your fund manager is forced to sell the bonds – you will lose money.

Mr Potter, whose favourite funds include Jupiter Financial Opportunities, Prusik Asia, BlackRock UK Alpha and Cazenove Income & Growth, added: "In today's market it is not solely about the return on your money – it is the return of your money, which is why I'm not afraid to invest in cash. A flat return is better than a 5pc loss."

Mark Harris, a portfolio manager at New Star, is equally cautious, warning investors hell-bent on buying corporate bonds to do their due diligence before buying.

"It appears that the no-brainers for all investors this year are treasuries [government bonds] and corporate bonds. But what if we enter a period in which defaults balloon to levels only seen previously in the Great Depression? While the investment grade corporates may have priced in this possibility, sub investment grade has not.

"Risks remain and credit analysts will have to tread very carefully," said Mr Harris. "While the risk-reward balance for much of the corporate bond market certainly looks appealing relative to equities, it does not mean that we will all definitely make money over 2009. Be careful with your selection of bond funds."

To avoid falling victim to fashion, investment advisers suggest that investors stick to the tried and tested route of asset allocation. In other words, do not put all your eggs in one basket.

Mr Walker warned corporate bond investors in it for the short term that if they do not actively manage the portfolio they will see capital values rise and then fall. "Our clients are medium-term investors and therefore the philosophy is asset allocation and a minimum five-year holding. So our clients will be holding corporate bonds – both high yield and investment grade – to diversify their portfolio and reduce risk," he said.

Mr Jordan added: "Our analysis shows that fund picking is a hazardous activity. People who have relied on this have portfolios that have no science of objectivity behind them whatsoever. If these people have been burnt by market volatility and are worried what further impact low inflation will have, now is the perfect time to review the asset allocation within their portfolio.

"The key will be to understand their attitude to risk, which is likely to be low if they are worried about low inflation, and select an asset allocation in line with that."

By way of a pointer, an analysis of deflation in the new Barclays Equity Gilt Study suggests that unwittingly diversifying into bonds may be no bad thing, given that the prospect of falling prices looms large.

The study found that in extreme inflation conditions, whether deflation or high inflation, portfolio diversification did not seem to be the best approach, given that returns are so heavily concentrated either in resource-based stocks in the case of inflation or in government bonds in the case of deflation.

http://www.telegraph.co.uk/finance/personalfinance/investing/4690549/Corporate-bonds-Dont-be-a-fund-fashion-victim.html