Why are investors playing a risky game?

Everyone who has even the most basic understanding of finance knows that you buy bonds - both government and corporate - when it looks like interest rates have reached a high, says Lorna Bourke in Money Marketing. That way you get an immediate high yield and the prospect of a capital gain as rates fall. You then sell them as rates bottom out and the reverse is likely to happen. So why then are investors pouring into corporate bond unit trusts at nearly double the rate of five years ago? Given that it seems clear that interest rates today are as low as they are going (the next move is almost certainly up), this is evidently the wrong thing for them to be doing.

Indeed it is, says Paul Farrow in The Sunday Telegraph. Those who swapped out of equities and into bonds a few years ago will have done well - corporate bonds outperformed equities by 30% in 2002 - but that won’t continue. The average corporate bond fund has fallen 1.7% since April, and given the interest-rate environment, the odds are that they will keep falling. So the “two in three” investors who walk into their local bank or building society with a view to buying a unit trust, and now walk out with a corporate bond fund in the belief that they are less riskythan equity funds, may well have a nasty surprise.

One reason to think that the bull market in bonds is definitely over is the rising risk of inflation, says Mark Cliffe at ING. Only five months ago, the bond markets were still rising in the belief that impending global deflation would keep interest rates low indefinitely. Now they’re in retreat as dealers point to the commodity markets, where prices have been rising sharply, as well as the global laxity of monetary and fiscal policies as signs that inflation may soon make a come back. In the US, the “plunging” US dollar, which makes imports more expensive, could also drive up US inflation and hence yields in the global benchmark US Treasury market.

The other indication that bonds have had their day for now is the narrowing of credit spreads (the premiums that corporate bonds pay out in yield over risk-free Government debt) in the corporate market, says Mike Monnelly on breakingviews.com. These hit their widest point for more than a decade in October 2002, as investors “panicked” over the health of the financial system. But now, after a “long bull run” in bonds, prices have risen to the level where the spread between yields on the risky and risk-free are looking “narrowish”, given the risks to the economy.

And while default rates (the extent to which corporate bond issuers failed to honour their interest and capital repayment obligations) fell for part of this year as the US economy showed early signs of recovery, and companies found it easy to refinance, it will rise again if the US economic recovery “sputters out”. Note that this is far from impossible. Recent economic data has been mixed, and the imbalances in the trade and budget deficits haven’t gone away. What’s more, rising stockmarket volatility could make it harder for the weaker borrowers to “refinance”. All this means that spreads may well widen from here, and that implies falling corporate bonds prices. Sensible investors will now take profits made during the “whopping” rally.

Let’s hope that this time around the UK’s independent financial advisors are making all these points clear to investors, says David Prosser in the Express. Because if they’re still pushing bonds as “less risky” products when there is actually a big risk of volatility and capital loss attached to them, we could find ourselves in the midst of yet another mis-selling scandal.