May 4, 2012 6:04 pm

Bond funds back in favour

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Investment-grade corporate bonds are still the most popular asset class among private investors – despite rising prices and concerns about future company failures.

Fixed-income funds outsold all others in March, according to the Investment Management Association, with strategic bond funds the best selling sector by far.

This week, Tesco Bank tapped into this enthusiasm by issuing a new version of its retail bond, offering to pay a coupon of 5 per cent until 2020, while HSBC launched a Renminbi-denominated bond – the first non-Sterling denominated bond open to private investors. Investors can purchase bonds paying an annual coupon of 2.875 per cent, and will benefit from any rise in China’s currency against sterling when the bond matures.

Advisers say low returns on cash and gilts have pushed investors to accept the higher risk of bonds, in exchange for an income that can keep pace with rising prices.

But, rather than invest in assets that offer the highest returns, such as equities or high-yield corporate (or “junk”) bonds, private investors are generally choosing lower risk corporate bond funds and strategic bond funds.

Research from Morningstar shows a similar story across Europe and in the US, with investors fleeing equities in exchange for bonds in recent months.

“A global bond boom is on,” says Dan Lefkovitz from Morningstar’s European research team.

Investor interest in corporate bonds cooled off last year, amid worries that the European debt crisis could spread to corporate credit markets. However, investors have regained their appetite for corporate debt in the face of high inflation.

Brian Dennehy, managing director of FundEx pert.co.uk, says bond fund managers believe that prices for corporate debt may be overestimating the risk of companies defaulting on their bonds.

But investors cannot expect to earn yields of more than about 4 per cent in high-grade corporate bonds, he points out.

Yields are being held back as corporate bonds continue to look attractive relative to sub-inflation returns on cash deposits. This is pushing more investors in bonds, pushing their prices up and pulling yields down.

Adrian Lowcock at Bestinvest favours the M&G Strategic Corporate Bond fund, which yields 3.85 per cent. Strategic bond funds give their managers more freedom to invest across the bond market.

“We saw corporate bonds as a theme in Isa sales this year,” Lowcock reports. “Investors are still worried about the Eurozone and the UK’s economy but what are the alternatives? If cash isn’t offering a positive return then there are limited options.”

Even so, Dennehy cautions that investors should make sure they know how bonds work before investing. Bond prices are calculated under the assumption that the capital will be repaid, but if something goes wrong at a company then repayment may not happen.

“Investors need to feel certain about the strength of the company issuing bonds and other sorts of debt it has issued. You want to know where you sit if the company does fail. How likely are you to get your money back?”

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