Bonds: Corporate bond funds

Bonds pay out a fixed income, known as the coupon. The running yield depends on the current interest rate, so bond prices fall when interest rates rise or rise when rates fall. Corporate bonds tend to trade at a yield premium to gilts (UK government bonds), reflecting the risk of default, and this yield spread can widen or contract, depending on the strength of the economy and an individual company's prospects.

Bonds have fixed lifespans and you should also look at the redemption yield, which reflects any capital loss or gain to be made on maturity, depending on whether a bond is trading above or below its issue price (known as par). Bonds rank above shares in a company's capital structure, so bond holders are paid out first if a company goes into liquidation.

Corporate bonds rated BBB or above are called investment-grade, whereas those with lower ratings are known as high-yield or 'junk' bonds. Fund managers may be able to spot opportunities for bonds to be rated upwards, allowing a capital gain, and try to avoid situations where bonds are downgraded, leading to a capital loss.

Given the risk of default – as in the famous case of Enron, which had been rated investment grade before it imploded – it makes sense to hold bonds through a fund for diversification. You should also consider holding bond funds inside your individual savings account (Isa), as bond interest is paid out gross into the tax-free wrapper, whereas dividends from shares are hit by basic 10 per cent tax, which cannot be reclaimed in an Isa.

Outlook

If economic conditions worsen, bond funds could benefit from falling interest rates, which could lead to rising bond prices. That said, a recession could lead to credit rating downgrades and defaults.

Bond prices have already risen, not only reacting to the recent US and UK interest rate cuts but also anticipating further cuts. Mick Gilligan, of broker Killik & Co, notes: "The yield on the 10-year gilt in June was 5.5 per cent, but it became evident that there were going to be problems in the credit markets so, as people moved into safe-haven assets, that yield went down to 4.5 per cent by December – that's a significant move."

The yield spread over gilts on BBB-rated corporate bonds rose from 0.4 per cent in June to 1 per cent in December, reflecting a higher risk of default. Credit ratings agency Standard & Poor's predicts that the number of downgrades in 2008 will be double the number of upgrades, and that defaults will rise from their current historically low level.

David Kauders, of independent financial adviser (IFA) Kauders, argues that investors should hold gilts in order to make capital gains when interest rates fall further. He argues: "The countertrend rally from 2003 to 2006 has now ended and the great bear market of 2000 to 2002 has resumed. Rising gilt (and US Treasury Bond) prices will now be the norm, and eventually there will be new lows in stock markets." See www.contraryview.co.uk for more on his bearish outlook.

On the other hand, Rob Harley, of IFA Bestinvest, says gilts are "fair value" now. He points to the yield curve, which shows future bond yields, noting: "It's saying to us that rates have got to fall dramatically, but that's already priced in." Mr Harley thinks there could be value in corporate bonds, though, saying: "If you look at the risk premium that you receive for investing in investment-grade bonds, it's at a historical high so there's a lot of bad news priced in."

Mr Gilligan expects to see the yield spread widen further in the first half of 2008 due to poor newsflow, creating more value for managers.

Recommendations

If you would like to hold gilts, you should buy them directly through your broker, rather than using a fund. Not only do you avoid paying a management charge (not needing to diversify against default risk) but gilts are exempt from capital gains tax, too, if held directly.

Mr Gilligan recommends Invesco Perpetual Corporate Bond (managed by Paul Causer and Paul Read) as a mainstream bond fund or, for a lower-risk approach, Standard Life AAA Corporate Bond (managed by Andrew Sutherland). He also backs CQS Rig Finance, an Aim-traded fund that yields 7.5 per cent from low-risk investments in oil supply infrastructure.

Mr Gilligan is wary of high-yield bond funds because of the greater default risk – spreads over gilts have widened from 1.3 per cent to 2.7 per cent over the past six months. His favoured high-yield bond fund is Artemis High Income, where manager Adrian Frost holds around 20 per cent of his assets in shares.

Emerging market bond funds could be an interesting angle, as many emerging market economies are now in strong positions. Mr Gilligan likes Threadneedle Emerging Market Bond (managed by Paul Murray-John) and emerging markets hedge fund Ashmore Global Opportunities.

Mr Harley also likes Invesco Perpetual Corporate Bond, but favours Legal & General High Income Trust (managed by David North) for high-yield bond exposure and Investec Emerging Market Debt (managed by Peter Eerdmans) for emerging market exposure.

Alternatives

Bonds are normally held through open-ended funds because, where UK-domiciled investment trusts hold bonds, they suffer internal taxation. The Association of Investment Companies is campaigning for a level playing field for investment trusts, where tax on bond interest would only be paid by the end investor.

Nevertheless, some investment trusts hold bonds for portfolio diversification and there are also a few dedicated bond investment trusts, which are based in the Channel Islands so that they can pay out gross interest. These include Invesco Leveraged High Yield, City Merchants High Yield, Henderson Diversified Income and New City High Yield.

As an alternative to using actively managed bond funds, you could use an exchange-traded fund (ETF). ETFs are low-cost index-tracking funds, which can be traded daily and are exempt from stamp duty. There are 12 UK bond and gilt ETFs – for more information, see www.londonstockexchange.com.

If you want to buy individual bonds, despite the risk of default, you should be aware that it can be hard to find research on them as a private investor. Try www.bondscape.net as a starting point.

There can also be dealing issues, as bonds are sold in fixed lot sizes. To hold bonds in your Isa, they must be investment-grade (or gilts), with at least five years left to maturity at the date of purchase.

TOP PERFORMING BOND FUNDS (as at January 2008)

Corporate bond funds

Emerging Market Bond Funds

Source: www.morningstar.com, figures to 17 December on a bid-price to bid-price basis, including reinvested gross income.

TOP PERFORMING BOND FUNDS

Gilt Funds

High-Yield Bond Funds

Source: www.morningstar.com, figures to 17 December on a bid price to bid price basis, including reinvested gross income