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A consumer&#39s view

Another disaster is looming and, unless IFAs move fast to advise clients, they could be in trouble. Just at the worst possible time, investors are pouring into corporate bond unit trusts at nearly double the rate of five years ago.

As any good adviser knows, you buy bonds – including corporate bonds and gilts – when interest rates have peaked so that you enjoy a high yield and the prospect of rising capital values as interest rates decline. You sell bonds when interest rates have bottomed out and the reverse will happen.

In July, a net £494m was invested in corporate bond funds compared with £258m in November 1998, just after interest rates last peaked at 7.5 per cent. Gross sales of corporate bond funds accounted for 24 per cent of £2.5bn gross retail sales.

Admittedly, some £271m of corporate bond funds were encashed in July. Hopefully, these are the people who invested in 1998, who have realised that interest rates have now bottomed out and the only way for capital values of corporate bond funds to go is down.

But there is still £21.2bn invested in corporate bond funds, the third-biggest sector after UK all companies at £63bn, with UK equity growth only marginally ahead at £21.5bn.

There is considerable evidence that these buyers have made their corporate bond fund purchases on the strength of advice. According to IMA statistics, more retail funds were sold through intermediaries than any other channel.

Yet evidence from a recent FSA investigation reveals that most investors have little or no idea of the risks involved – that is, that when interest rates start to rise, the capital values of corporate bonds falls until the yield on the bonds comes into line with those available elsewhere.

If you do not think it will happen, just stop for a moment and look at what the money markets are telling us. Short sterling futures have fallen sharply in recent weeks. The pricing of these contracts reflects market perceptions of where interest rates are going.

The December contract recently fell to 96.090, indicating a half percentage point rise in the bank base rate by the end of the year. The June 2004 contract fell by 0.13 to 95.620, implying a whole percentage point rise in the bank base rate by next June.

The banks are in it up to their necks. According to IMA statistics, corporate bond funds accounted for nearly 70 per cent of all unit trusts sold by tied agents in July compared with only 16 per cent which were bought off the page.

Clearly, investors have been looking for income but the time has come when both IFAs and banks&#39 tied agents must point out to customers that although corporate bond funds offer a more attractive yield than deposit accounts, as interest rates rise, investors are almost bound to lose money.

For conscientious IFAs, this should not be a problem and many may well have advised their clients to get out already, hence the £271m of corporate bond encashments in July.

A good IFA presumably produces a quarterly or half-yearly newsletter advising clients of investment opportunities as well as areas to avoid. The possibility of rising interest rates and the effect it will have on capital values of all bonds, including gilts, must feature prominently in most IFAs&#39 circulars.

But the counter staff at banks have no such brief to maintain an ongoing advisory role with customers. Ehen the complaints start to roll in – and roll in they will – it will be no use the banks protesting that they are just salespeople.

The banks&#39 marketing men defend corporate bonds as low-risk investments, claiming that the possibility of corporate bonds falling by 40 per cent – as shares have done over the past three years – is far less likely than of shares going down yet again.

They clearly do not understand what they have been selling. For corporate bond funds to lose 40 per cent of their capital value, it would simply take an interest rate rise of about 1.5 per cent – certainly not beyond the realms of possibility when the money markets are already predicting a rise of 1 per cent by next June. Will they ever learn?

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