Gloom makes bonds glitter

Experts believe corporate bonds are heading for their biggest success in living memory.

Corporate bonds have long been a magnet for risk-averse investors. Financial planning wisdom would tell you that while you should have most of your money in equities when you're young, you should seek safety in good-quality corporate bond funds as you approach retirement.

However, bonds have just had one of their worst periods on record, with the average investment-grade bond fund losing more than 11 per cent of its value. The main reasons for this collapse are, first, fear that the number of corporate failures is going to soar, and second, that many hedge funds have been forced to cut their borrowing in the credit crunch. And the only way to pay back their borrowing has been to sell assets in their funds – including ones they may believe will be good value.

Corporate bonds are now priced at levels not seen since the 1930s. When the price of corporate bonds drops, their yields, proportionally, go up. The spreads – the difference between the return you could get on a government bond and the yield you could get on a corporate bond – have become so wide, that the market is effectively predicting that more than one in three of all investment-grade companies are going to go bust over the next five years.

The worst corporate default rate seen over the past 40 years has been only 2.8 per cent – which means that no more than one in 35 investment-grade companies has gone bust in any five-year period over the past four decades – and the average is 0.8 per cent.

Jim Leaviss, head of retail fixed interest at M&G, says default rates may well be much higher this time round, but it seems unlikely that more than one in three investment-grade companies will collapse. "Investment-grade companies do go bust," he says. "We've seen Lehman Brothers go bust this year, and AIG ran into some severe difficulties – so we mustn't let ourselves think it's impossible. But now, if you had a portfolio of 100 investment-grade bonds, you'd need 39 to go bust before your portfolio would make a return that underperformed an equivalent portfolio of government bonds. These are the most compelling spreads any living fund manager has seen."

It's worth remembering that even if companies do go bust, bondholders tend to do much better than shareholders. Bondholders can expect 40 to 50 per cent of their money back, whereas shareholders will usually get nothing.

For these reasons, bond fund managers believe that the next couple of years could be extraordinary. While bond funds would usually be expected to return around 10 per cent a year, some managers now believe funds generate equity-style returns in 2010. In the high yield market, there is the potential for high double-digit returns.

Paul Read, co-head of fixed interest at Invesco Perpetual, says: "Our outlook is very bullish. Headline news will probably be nasty throughout 2009, but tremendous amounts of bad news are priced into our markets. Default levels we'll never see are priced into our markets, and we can buy into sector after sector with equity-like returns, without equity-style risks."

Where to buy

You can buy individual corporate bonds through stockbrokers such as Hargreaves Lansdown, E-Trade and TD Waterhouse. They tend to be issued at a price of £100 a bond, but after issue their price will vary as they are traded. If you hold the bond to maturity, you will still get back £100, as well as being paid the annual coupon – a fixed payment similar to a dividend.

A better way to get access to the market is to buy a bond fund, within which a manager will trade a portfolio. There are three main types of corporate bond fund – investment-grade, high yield and strategic. A strategic bond fund tends to invest in a mixture of high yield and investment grade.

Meera Patel of Hargreaves Lansdown, the financial adviser, says investors looking for a solid investment-grade corporate bond fund should consider Invesco Perpetual's Corporate Bond fund, managed by Paul Causer and Paul Read – two of the industry's most consistent managers. For strategic bond hunters, she recommends Richard Woolnough's M&G Optimal Income fund. For those looking for a high-yield fund, she picks out the Royal London Sterling Extra Yield fund, which invests in companies lacking credit ratings. Instead, the managers conduct their own research.

It's well worth seeking advice before you buy. To find an independent adviser, visit www.unbiased.co.uk.

What is a corporate bond?

Companies use corporate bonds as a way to borrow money. Firms promise to pay investors an annual coupon – usually in two tranches – and to return all the original sum at the end of a fixed period. A new bond is normally issued at £100, but then trades, which makes its price vary. The price will be influenced by how likely investors believe the company will go bust, as well as how its return compares with government bond returns, and how long it has until maturity.

Investment-grade bonds are credit rated BBB or above; high-yield bonds are rated lower. Lower company ratings mean higher coupons.