Corporate Bond Funds: Less racy option delivers steady returns

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Fickle investment fashion has moved on, leaving corporate bond Isas forlorn.

UK corporate bonds accounted for £1.27bn of net Isa sales in 2003, according to the Investment Management Association. Last year this had fallen to £259m.

Like a once-trendy bar that has lost its hip status, the sector offers good service, but without the crush.

Corporate bond Isas are seen as “slow and steady” investments for the cautious, and are often used to help generate tax-free income for those nearing, or already in, retirement.

Funds are predominantly invested in the corporate debt of publicly-quoted companies, which pay a fixed annual income. Funds often hold other fixed-income investments such as government bonds.

When researching the sector, investors will come across the use of credit ratings to describe the financial strength of companies issuing bonds. The rating gives an indication of the company’s ability to fulfil its commitment to make payments to the bondholder.

Investment grade bonds are those issued by companies given high credit ratings – from AAA down to BBB- – by the main credit-rating agencies. They feature in Isa corporate bond funds aimed at cautious income-seeking investors.

The increasing use of “lifestyling” in financial planning has opened more opportunities for bond investments. Lifestyling usually involves switching from equities to bonds and other fixed-interest savings as retirement approaches.

Government-endorsed stakeholder equity funds designed to take the new Child Trust Fund payments of £250 will also have to switch children’s savings into lower-risk investments from the age of 13, in preparation for the funds’ withdrawal at age 18.

Paul Causer, joint head of fixed income at Invesco Perpetual, suggests that the “steady” aspect of bond funds is exactly what should be stressed in 2005. Investors grown used to double-digit returns from high-yield bonds in the past couple of years may be disappointed.

In 2004, the conservatively invested Invesco Perpetual Corporate Bond fund returned 5.5 per cent, while the racier Invesco Perpetual Monthly Income Plus made 14.3 per cent, putting it first of the 43 funds in its sector.

“The market has tightened to a point where you are not getting extra value in terms of the extra risk you are taking on,” says Mr Causer. The Invesco Perpetual fixed-income team believes a generally benign economic outlook has been priced into the bond market, and there are no surprises on the horizon.

He explains: “Bond funds have had a couple of very good years, but the retail product is not offering compelling returns at present. Bonds have their place for investors, who should manage their expectations.”

Mr Causer advises holding on to existing bond funds. But he believes equities, especially in the dividend-focused UK market, offer better value for people placing new money in 2005.

Others are more upbeat about potential returns for bond investors. David Roberts, head of fixed income investments at Aegon, says: “Bond funds are frequently pigeon-holed as steady and boring, and that’s largely true of a large portion of the market but there are funds with the potential to deliver stellar returns across the economic cycle. Different corporate bond funds will suit different investors.”

Mr Roberts warns that new regulations on the holdings allowed in bond funds were designed to reduce the risks to investors from the use of derivatives, but have led to wide variations in interpretation.

“There are funds with the ability to run long and short positions, and significant currency positions,” he explains. “Sometimes the line between equity and bond funds is blurred.”

He suggests checking, and understanding, the make-up of any fund before buying. “It’s always appropriate for people to understand what they are investing in.”

Equity fund managers are notoriously unwilling to give away more than the obligatory “top 10” holdings information to investors, for fear of helping rivals. But Mr Roberts says bond fund managers are more accommodating and will disclose what is in their portfolio.

The corporate bond market offers three ethical bond funds. Rathbones’ Ethical Bond Fund chooses bonds that meet a range of investment and ethical criteria. Some 80 per cent of the holdings are in lower-risk bonds.

All potential investments are screened by the fund managers, and then by the firm’s ethical team. “Basically, they work out whether the company is doing anything that will harm the share price – that’s the extra layer of screening,” says Rathbones’ David Holloway.

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