Corporate bonds: Bargain or bubble?

The average yield gap - the difference between yields on investment-grade sterling bond yields and gilts - has ballooned out to around five per cent. As Legal & General credit strategist Ben Bennett pointed out recently: "History suggests that the current level of compensation for an investment grade portfolio is extraordinary. Even in the teeth of the early 1990s recession, the cumulative defaults over a five year period for investment grade corporate bonds was only 2.4%. It would take just six months of today's extra yield to have compensated investors for five years' worth of defaults."

Of course, just because this level of expected default is unprecedented, that doesn't mean it couldn't happen. Moody's recently said that it expects a "tidal wave of defaults" in sub-investment-grade debt. "We certainly think that this credit cycle will be worse than the last two in the early 1990s and 2000s. In fact, in 2009 we expect to see the largest number of defaults since the advent of high yield bond market in the early 1980s. And the default rate for non-investment grade bonds may reach levels even higher than those registered during the Great Depression," said the company's senior vice-president, Kenneth Emery.

And default is not the only, or even the biggest risk. Another thing to watch out for is "fallen angel" risk. Most big bond investors won't touch anything that isn't investment grade. So a downgrade to junk status is literally the kiss of death for a bond. If you're investing directly in bonds, this should form a key part of of your research: what's the current rating, how close is a bond to a downgrade to junk, and what are the chances such a downgrade happening. The table below shows some European bonds that are perilously close to such a downgrade (ie, they are currently rated one notch above junk, and with a bias towards further downgrade).

Source: Standard & Poor's

Be aware too that the high average yield gap conceals huge sectoral variations. Bonds issued by companies in cyclical industries trade at even bigger yield premiums, while for bonds issued by defensive companies like utilities and pharmaceuticals, the yield gap can be less than half the average.

Our top corporate bond picks

We cover bonds every week on our website via the bond of the week feature. This is contributed by Mark Glowrey, a director of Stockcube Research, who is a former bond trader. Mark also runs a model portfolio (shown below) and many of the instruments featured in the bond of the week column are constituents. The links in the table take you back to an article on the instrument in question. The key thing about this portfolio, which is comprise of all investment-grade debt, is the spread of yields, maturities and industries. The Portman and Bradford & Bingley bonds are actually Pibs, which differ from bonds in some material respects.

Top corporate bond funds

We profiled several leading corporate bond funds earlier this year. One of the key performance differentiators was the exposure to high-yield bonds, and exposure to the financial sector. Our top pick is the M&G Corporate Bond fund, run by Richard Woolnough.

You can read a fund tip on this fund , or download data on it from our fund data tool here.