Personal Finance: Down the junkyard

Are junk bonds a good investment or a load of rubbish, asks Teresa Hunter

Falling interest rates may raise a cheer from Britain's nine million homebuyers, but they can cause real hardship for the country's savers, particularly those trying to live off the income from their nest eggs.

Interest from bank and building society accounts will tumble from the beginning of next month to around 4.5 per cent gross, 3.5 per cent net of tax, following the latest cut in the cost of borrowing. At these levels, even a fairly substantial pot of 100,000 pounds will only produce pounds 300 monthly income.

Returns from Government bonds also slid sharply from 6.3 per cent last year to 4.5 per cent, and are expected to continue to decline further as our interest rates converge with those in Europe, where bank rates are 3 per cent.

Which explains why a new breed of high income funds which are flooding on to the market are proving popular with investors determined to narrow the income gap.

Their advocates believe junk bond funds represent one of the best investment opportunities currently available. Their critics argue that novice savers are being persuaded to risk their shirts on junk which may never be able to meet its obligations.

How safe is investing in bonds?

Usually, as safe as it gets. Most bond funds invest in fixed interest stocks, which guarantee an income until maturity. When issued by governments in their own currency, there is virtually no risk of default, because they simply print currency to meet their obligations.

These bonds, called gilts because they are considered a "gilt-edged" investment, are currently yielding about 4.5 per cent. But a word of warning. It is not unknown even for sovereign states to run into difficulties. Russia and Indonesia have recently struggled with foreign debt repayments.

So only bonds issued by governments are safe?

Not entirely. A number of blue chip companies also issue bonds, which are not as safe as gilts, but are the next best thing. They typically yield 1 or 1.5 per cent more than gilts, and took off with the launch of corporate bond personal equity plans in 1993.

The likelihood of these companies defaulting is thought to be very slim, but the risk is assessed by credit rating agencies, like Moody's and Standard & Poor's. The safest corporate bonds get a triple A or double A gold star rating.

So what's the big risk?

These high yielding funds aren't investing in the triple A rated bonds. So-called "junk" corporate bonds promise a return of 7.5 per cent or 8 per cent by buying bonds of companies with much poorer ratings, which means they also have a more pronounced default risk. Anyone who needs to pay 3 per cent above the going rate of interest doesn't look like the best bet in town.

So they're too risky to touch?

Not necessarily, as long as you understand precisely what you are investing in. Although new to the UK scene, the junk bond market has thrived in the US for some time. Very respectable companies issue these bonds. There are currently a flurry from telecom firms like Orange or Colt Telecom, who are too new to have earned higher ratings.

M&G's Theodora Zemek believes that investors are over-compensated for the risk the bonds will default, which he puts at 3 per cent. Furthermore he claims that the credit rating agencies are not necessarily a good guide to a company's credit-worthiness.

She argues: "American studies have shown that there is a low degree of correlation between credit ratings and the likelihood of default. They are useless when it comes to predicting so called `event risk'."

She believes the best deals are with companies who are likely to be upgraded during the life of the bond, and these are the investments she actively seeks out. That way you buy into a high yield, with a company which is a much lower risk than implied by the yield.

Does anyone agree with her?

Yes. Scottish Widows, Fidelity, Framlington, Perpetual and Schroder have all launched high yielding copycat funds which mix gilts, triple A rated bonds and junk bonds.

What do the critics say?

They have three main criticisms. Firstly they maintain that investors do not understand the risk they are taking when they buy these funds, and think they are as completely safe as other bonds.

Second, they warn that higher than normal charges on a bond fund, also puts the capital at risk. Finally, the jeremiahs predict a sharp rise in the rate at which these bonds default if the world economy stumbles into a recession.

Murray Johnson's Chris McGinty is convinced that any promise of a yield of above 6.5 per cent in the UK, and above 5.5 per cent in Europe, must put your capital at risk. He says: "The real concern is investors looking for income who buy `off the page'. They are more likely to buy a high headline rate without understanding the risks."

He is also concerned that a flood of new funds chasing a limited amount of stock, will push up prices in the short term, which could well crash later.

BESt PEP, the London-based independent financial advice firm, also warns about the risks, but concludes that, on balance, there are attractions for investors desperate for income, provided they understand the pitfalls.

Jason Holland,a director at BESt PEP explains: "There is a much greater risk of capital loss than with a conventional corporate bond fund, especially if charges are taken from the capital. If the current economic slowdown moves into a steep recession there is a likelihood of an increase in the default rate on less creditworthy corporate debt."

And even Perpetual's Paul Causer admits that there is a greater risk of default with a junk bond than with the share of a blue chip company.

How often do junk bonds default?

Surprisingly little, but when they do it can be spectacular. Mismanagement of junk bonds was at the root of the "savings and loans" scandal in the US, where an entire financial sector was all but wiped out in the early Nineties.

More recently in the UK we have seen Barings Brothers and Queen Moat default, although debts were restructured and some payments made.

So what's the best advice?

As always, if you can afford to take a risk, buy a little bit of everything. If you can't, stick with the traditional gilt and triple A corporate bond funds.