Mark Dampier: Ah, corporate bonds, we meet again

The Analyst

Perhaps I should apologise to regular readers for sounding like a broken record and constantly banging on about interest rates. The simple reason is that I don't believe many people realise where interest rates are likely to go over the next few months. The Bank of England meets again next Thursday and I expect to see another substantial rate cut. I think that, by February, interest rates could be 1 per cent, a level never seen since the Bank of England was formed in 1694.

So what does this mean for instant-access bank accounts? Well, rates are bound to be slashed and the return on cash is likely to be paltry. Now, I would certainly not advocate that people shift all their money out of cash deposits. However, many investors, having been spooked by falling stock markets, now have excess money in cash. Will they be happy to accept a minuscule cash rate? Or will they look to put some of those assets elsewhere in search of returns?

Those who can stomach a bit of risk in exchange for the potential of greater returns should consider the incredible opportunity offered by corporate bond funds. This week, I am highlighting the Investec Sterling Bond Fund, which has a highly flexible investment mandate and can invest in overseas corporate bond markets, UK corporate bonds or high-yield bonds.

Anyone looking at the performance of corporate bonds over recent months will not be enamoured with the thought of holding any themselves. To use a technical phrase, they have been absolutely mullered. A major reason behind this is the unequal treatment by regulators, particularly in the USA, of major institutions that have got into difficulty. Some have been saved while others have been allowed to go to the wall, and this has scared off long-term holders of corporate bonds. Over the past six months or so, we have seen a huge amount of distressed selling as institutional investors, desperate for cash, have dumped bonds on to the market and driven prices down. The result is that yield spreads (by which I mean the difference in yield between government bonds and corporate bonds) have blown out to levels not seen since the 1930s.

So let's look at what will have to happen in order for current bond prices to seem accurate. In the 1930s, about one-tenth of investment-grade bonds defaulted on their debt over a five-year period. The current market is predicting that half the market will default! Now, I'd be the first to say that the current economic outlook is grim, but is it really five times worse than the Great Depression? Surely that cannot be right. Even a situation that is equally as bad as the Great Depression means that there is value in parts of the bond market.

As ever, it is impossible to pick the exact best moment to buy. It is entirely feasible that things will get worse before they get better for bond investors. However, while they are waiting for a recovery they are receiving good yields (which is tax-free in an ISA or Sipp, don't forget). For the first time, the potential medium-term return on bonds is every bit as good as, perhaps even better than, that in the equity market.

The Investec team are extremely experienced in this area, using a combination of economic research to analyse the overall situation and individual bond research to pick up attractive bonds. At the moment, the portfolio has more in non-consumer-focused, defensive areas with good cash flow, such as utilities.

Bond investing is a huge part of Investec's business so investors are getting a very dedicated team under fund manager John Stopford. The current running yield is 6.6 per cent; the gross redemption yield is 9.3 per cent.

While the news looks awful, both economically and in the markets, investors should try not to bury their heads in the sand about it. Market falls such as this bring the most incredible opportunities along in due course. Now is the time to be looking at some of these opportunities, and corporate bonds must be one of the first ports of call.

Mark Dampier is the head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more information about the funds included in this column, visit www.h-l.co.uk/independent