Bond fund returns expected to slow

Investors in fixed-income funds need to pay attention to the credit rating and duration of the bonds they hold as returns slow, according to advisers.

UK bond funds surged in popularity in 2009, with total fund sales rising from £1.9bn to £10.7bn. Retail investors accounted for 90 per cent of these inflows, according to the Investment Management Association.

Many investors were attracted by the ability of the top-performing bond fund managers to deliver equity-like returns of 40-50 per cent a year, without equity-like price volatility. Sterling Corporate Bond funds were the bestselling sector from the last quarter of 2008 until the third quarter of 2009.

However, sentiment in the fixed-income market has been changing since the end of last year.

A recent Moody’s report stated: “Following the rally experienced by the bond market in 2009, we expect a consolidation in bond prices to take place. Now that the significant market shift (the catching-up following the collapse) is complete, credit spreads have fallen towards their historical levels.” Credit spreads measure the difference between the yields on corporate bonds and the yields on government bonds. They widened rapidly in late 2008, as corporate bond yields were pushed up by plummeting prices, due to fears that bond issuers would default on their payments.

But Dennehy Weller & Co, the adviser, warns that rising gilt yields, rather than falling corporate bond yields, could now pose a greater threat to spreads. Managing director Brian Dennehy says falling gilt prices are now the primary risk for bond fund investors as markets become more concerned about the UK’s rising debts.

“Over the past 10 years, 80 per cent of the return from investment-grade corporate bonds can be explained by the return on gilts,” Dennehy says. “To a significant extent, where gilts go, the investment-grade corporate bond market will follow.”

UK bond funds have significant allocations to gilts – having increased their average holdings in government bonds from 22 per cent to 40 per cent between mid-2008 and the end of 2009, according to Moody’s.

But while gilts have been regarded as a haven, few analysts favour them as fund holdings now.

Moody’s says the UK government is likely to have to issue more gilts and, with the Bank of England suspending its buying of gilts through its quantitative easing programme, prices look likely to come under pressure.

At the same time, some bond fund managers have been buying into corporate bonds with lower credit ratings to maintain the yields on their funds, as conditions in corporate bond markets have a normalised approach known as ‘moving down the credit curve’.

“Most of the strategic bond funds are taking more credit risk to achieve higher returns this year by moving into junk bonds or bank capital instruments,” says Paul Causer, co-head of fixed interest at Invesco Perpetual.

So, private investors who reaped easy returns last year now need to scrutinise the holdings of their bond funds. Moody’s analyst Marina Cremonese says: “Investors need to pick the right credit, pay attention to how the portfolio manager selects the credit, ask what is the investment mandate to achieve the return as promised – and they need to feel confident about their fund managers.”

Investors are also advised to keep an eye on the duration risk – the risk that long-dated bonds, which have five years or more to go until maturity, fall in price as interest rates rise.

Jason Butler, chartered financial planner at Bloomsbury Financial Planning, believes in avoiding as much risk as possible when investing in bonds – as their role in a portfolio should be to damp the volatility of other, more risky investments.

“If you are buying bonds to limit volatility, buy short-dated high quality ones,” he advises. “If you are buying them to immunise against long-term nominal liabilities, buy long-dated high quality ones. If you are buying for high returns, buy equity assets instead.”

But, in spite of these risk factors, many analysts are still taking a positive view of bond funds. Their consensus is that the peak of bond defaults has already passed and credit ratings will further stabilise this year.

Bond funds are also attracting capital flows from investors moving away from money market funds due to low returns, according to Moody’s.

Sterling money market funds currently offer on average a return of 0.36 percentage points above the London interbank interest rate (Libor) – although this adds up to less than 1 per cent, with Libor still as low as 0.5 per cent.