Investors have been piling into gilts and corporate bonds for months to escape falling equity markets – but not all bond funds are as low-risk as they may appear, advisers warn.

Their attractions have become quite clear in recent months, though. Forced selling by hedge funds at the end of last year meant that corporate bond prices fell, pushing their yields up.

Even now, the yields on many investment-grade bonds – the safest form of corporate bond – are more than 9 per cent. This suggests the market is pricing in bond defaults by a quarter of FTSE 100 companies – a situation that bond analysts think unlikely.

Investors seeking income have therefore rushed into bond funds, which are still being described by financial advisers as offering a “once in a lifetime” investment opportunity.

Government bonds, such as UK gilts and US Treasuries, have been a popular choice for even longer. In fact, global bond funds were the top performers in 2008, thanks to their exposure to government debt outside the UK.

Jim Leaviss, head of retail fixed income at M&G, says gilt returns since the credit crunch started have been more than 20 per cent. But he adds that, over the next couple of years, he expects corporate bonds to dramatically outperform gilts.

“By lending to big, low-risk companies, investors can receive yields upwards of 6 per cent a year, with the prospect of double-digit yields if they want to take on a bit more risk. This makes corporate bonds very attractive as the income on bank savings collapses,” he says.

Even so, there have been warnings that bond funds are not all as safe as investors assume.

Gilts, for example, are not risk-free. This week’s Budget unveiled plans to borrow billions by issuing gilts, causing the cost of insuring against government bond defaults to become higher than the cost of insuring against corporate bond defaults by blue-chip companies – hardly a sign of confidence. And if the market is flooded with gilts, prices could fall further.

Quantitative easing, which was intended in part to narrow the spread between corporate bond and gilt yields, has also failed to improve confidence in the credit markets.

Not all bond funds invest in the same holdings, either.

One issue facing bond managers is whether to invest in financials, which make up about 40 per cent of the index. Bonds issued by some banks are a particular source of concern – the government’s part-ownership of banks has led to worries over what this might mean for bondholders.

Many bond managers also invest in subordinated debt. Jonathan Blain, a partner at private wealth manager IPS Capital, has calculated that a typical corporate bond fund has as much as a third invested in subordinated debt, which is a riskier holding than investment-grade debt.

For example, Ian Spreadbury, manager of Fidelity’s MoneyBuilder Income corporate bond fund, is investing in deeply subordinated bank debt, although he is underweight in financials. He admits the risk of buying subordinated bank debt is that the government could take further stakes in banks – but he thinks this is “highly unlikely”.

John Hamilton, manager of Jupiter’s Corporate Bond Fund, sticks to senior sub-
ordinated bank debt, pointing out that more deeply subordinated debt has weakened considerably because of concerns that interest on the debt might not be paid.

Hamilton mostly invests in non-financial sectors, though he does have positions in HSBC and Standard Chartered, as he says they are at lower risk of nationalisation.

Blain also warns that liquidity may be an issue for investors who want to get their money back. He has stopped allocating money to bonds, saying: “We are concerned that so much money has been invested into retail corporate bond funds that liquidity on exit will become an issue.”

Given these concerns over bond funds, investors are advised to check carefully the underlying holdings of the fund they opt for and spread their exposure.

“Managers are polarised between those with financials and those without,” says Ben Yearsley at Hargreaves Lansdown.

“Those without have been the best performers over the past year, but that may not be the case now – you don’t want to get caught too exposed one way or the other.”

He recommends that investors hold a mixture of Jupiter Corporate Bond, M&G Strategic Bond, Invesco Perpetual Corporate Bond or Henderson Strategic.

Investors should also focus on bond funds that have spread their risk and have a large number of holdings.

“Safety is to be found in a diversified portfolio of solid businesses that are likely to be able to survive a global recession, maintain their interest payments and not breach covenants,” says Hamilton.

As with any investment, the less risk an investor wants to take, the lower the likely return. Hamilton does not focus exclusively on ultra-high quality investment-grade bonds as he doesn’t think the return is high enough. But he is also avoiding high-yield bonds, also called junk bonds, as the risk is too great.

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