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Sleep tight with corporate bonds
Jul 10, 2006
Anna Lees-Jones, co-manager of the Investec Sterling Bond Fund tells MoneyWeek where she’d put her money now.
I don’t expect that many MoneyWeek readers think about bonds when they wake up on a Sunday morning, but bonds have not been the boring investment they’re often assumed to be over the past 15 years. Anyone who invested £100 in corporate bonds at the end of 1990 would now have £538, with gross income reinvested, compared with only £393 in gilts and £373 in equities. The compound return after inflation over the last ten years has been 8.5%, 6.5% and 5% respectively, according to Barclays Capital. Did that get your attention?
Over those ten years, these returns were also achieved in the more investor-friendly ‘tortoise’ (rather than ‘hare’) way. Corporate bonds only saw two years of negative real returns (1994 and 1999), whereas gilts had four years (1990, 1994, 1999 and 2003), and equities five (1990, 1994, 2000, 2001 and 2002). As you would expect, the decline in equities was considerably larger than for either gilts or corporate bonds.
What is the future of bonds?
That puts the past into some perspective. What about the future? Over the past few years, there has been much discussion about bubbles in the corporate bond market, and early this year it was certainly true that corporate bonds were expensive. However, even during the sell off in March and April, the decline only cancelled out the gains made in January and February.
Demographic change will continue to help corporate bonds perform well. The developed world has an ageing population, with the ‘baby-boomers’ generation approaching retirement. As it does, it will be encouraged to buy bonds to receive a good, low-risk income in retirement, and this could drive the price of those bonds even higher. Many pension funds have already been increasing exposure to corporate bonds as they look for ways to increase their income. Corporate bonds can do this for them as they provide an extra ‘spread’ over gilts.
The risk of default on corporate bonds
Do note, though, that this excess yield or spread is there for a reason: the investor is taking on additional risk, the most significant of which is that firms could default on their obligations to bondholders. Default rates are currently extremely low – below 2% for speculative bonds globally – and Moody’s forecasts this to deteriorate to only 3% over the next year, compared to a 4.9% historic average. Yet, even though corporate bonds tend to offer lower risk than equities, risk still needs to be managed. I would never recommend investing in just one or two corporate bonds because they have an asymmetric risk profile: they offer the opportunity to make moderate gains, but come with the small risk of large losses after default. That means diversification is vital; I would always invest in a fund.
Sectors in the credit market that I find attractive are utilities, especially following the regulatory reviews that have fixed prices and improved clarity; asset-backed securities, where there is a predictable business backing the bonds, such as rents from Tesco; and the insurance sector, where further regulation is pushing companies to improve capital bases and disclosure.
If you don’t want to get a nasty surprise from your investments, then I would consider putting a portion of your savings into a corporate bond fund. Currently, the main investments in our fund are in GE, Credit Agricole, Network Rail and Yorkshire Electric bonds.
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