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This is the fourth part of a series looking at regions and investments many have forgotten, but still offer good returns and yield. Telegraph Money has also gone in-depth on Europe, Japan and emerging markets.
For decades, funds that lent to governments and companies via bonds were a staple of many portfolios. However, central banks distorted the markets by printing money and buying bonds, forcing down yields and making them less attractive.
But there is still yield and return on offer if investors know where to look. Many believe corporate bonds have something to give despite investors turning cold on the sector. British investors have pulled nearly £2bn from corporate debt managers in the past 18 months.
The average yield on a high-quality corporate bond – issued by a company very unlikely to default – is just 2.1pc. Investors have been able to get an average 4.2pc from the British stock market, and so have turned their backs.
If you want to hold a bond to maturity, the main risk is that the company defaults on its debt commitments and cannot pay back lenders. High profile over-borrowers like Pizza Express have irked investors by changing the terms of their bonds, leaving many assuming the companies have pushed themselves to the limit and may not honour their commitments.
There is also the risk that the Bank of England, or other central banks, start meaningfully upping their official interest rates. Every increase in rates means bonds lose value. This becomes worse the longer the bond is from being fully paid back, known as its “maturity”.
Despite the weight of evidence against lending to companies, there are some who believe the fire sale since the financial crisis has been overdone. Professional investors are backing corporate bond funds for both yield and capital return.
Good returns and a Brexit discount
Kelly Prior of fund firm BMO said there was a case to buy corporate bond funds for multiple reasons.
“There is a very low rate of defaults from companies and little indication this is going to change, apart from some areas such as retailers,” she said. Ms Prior believes inflation will remain relatively flat in the near future which should help protect the value of bonds.
“Those with a need for steady income and a stable capital base need to remember the role that corporate bonds play in a balanced portfolio,” she added. Hinesh Patel of wealth firm Quilter said: “You’re getting a yield of above 2pc. This is quite a good difference compared to bank rates of 0.75pc and there is still a good opportunity for capital gains. We see inflation declining over the next 18 months so bond prices are low enough to offer value, especially with the yield.”
However, Mr Patel said there’s a quirk in the market that some bond managers are taking advantage of. Investors have sold off bonds issued in Britain, yet some of these bonds are from non-British companies.
“These companies have no exposure to the pound or the British economy but have been caught in a Brexit discount. Owning them gives investors exposure in the right currency, but without the Brexit worry,” he said.
Jim Wood-Smith, of wealth firm Hawksmoor, said he had been adding corporate bonds to his portfolios. “Whoever wins the election is going to have to borrow a massive amount. This means government bonds – that we would traditionally use as for diversification – will be poor value for a while. But the economy is likely to improve under a Conservative administration, so corporate bonds should be a better place to be.”
‘Bonds are a promise’
Despite these positives, investors still have reservations over whether corporate bonds are useful, and what their purpose in a portfolio is.
Traditionally it has been to be a halfway house between safe-haven government bonds and riskier stocks. They typically fall less than stock markets in a downturn but will provide a better yield and return potential than plain government bonds.
Investors have been turning elsewhere for this, opting for alternatives such as property or more obscure infrastructure investment trusts – that provide much higher yields. Ms Prior believes corporate bonds can still play this role.
“The yield from stocks or property is not like the yield on a bond, the latter is a promise. Companies have to pay out all their bondholders before shareholders get anything if they fail.
“In struggling markets the stability of a steady income stream coming from a company that will pay you back the money you have lent them at the end of the bond’s life, should be a stabilising element within a balanced portfolio,” she said.
Mr Wood-Smith said his moderately risky portfolio has around 30pc in bonds, of which 5pc is invested in British corporate bonds.
Investors have a choice to make when picking funds. They can opt for a plain corporate bond manager, or pick a “strategic bond” manager, who will invest in a range of bonds depending on the best value and price. The latter option means investors will not always know which types of bonds they own – as managers can quickly shift their portfolios – but they potentially offer better returns and yield.
Ms Prior recommended the TwentyFour Corporate Bond fund. Its manager, Chris Bowie, has run the fund since launch in 2015, and has returned 24pc versus 20pc for the average corporate bond fund.
For more flexible bond funds, she suggested the Henderson Strategic Bond fund run by veteran manager John Patullo and Jenna Barnard. The duo have returned 72pc over the past decade, versus 64pc for the average “strategic” bond fund.
This is a four-part series from Telegraph Money on unloved markets. It will be published every day for four days.
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