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Can the bondwagon keep rolling?

As equity markets continue on their downward spiral, investors are boosting their bond weightings. According to the IMA, net sales of funds in the UK corporate bond sector reached £2.6bn last year – almost double the £1.4bn invested in UK equity income funds.

But some in the industry are less convinced by the bond story. Bates Investment Services head of research James Dalby says: “The bottom line is that investors always chase the market and it is the worse thing they can do.

“Bonds are at their peak. Investing in them is perpetuating the dangerous cycle of buying assets that have already had their best run.”

Dalby points to a portfolio weighted 45 per cent in equity income, 20 per cent in corporate bonds, 20 per cent in property and 15 per cent in cash. Over three years to last December, that portfolio neither grew nor fell. In a raging bear market, he says that is excellent performance and leaves investors well positioned to take advantage of an equity rally.

But many IFAs say they are struggling to persuade clients not to plough into corporate bonds. The main reason they cite is the potential impact a war in Iraq could have on the stockmarket, which has made investors even more nervous.

Even fixed-interest fund groups concede that bonds are not immune from volatility although they argue that different types of bonds can counter even the most hostile economic environment.

Threadneedle communications director Richard Eats says: “If the war ends quickly, Western economies could surge and inflation may become a problem. That is bad for government and high-quality bonds because the income and final payment they make will be worth less in real terms. But it is good for high-yield bonds because companies are in a better position to pay back their debts and the risks are lower.”

But if war nudged the UK into deflation, companies could find it harder to pay back debt – a situation that would favour lower-risk, investment-grade bonds. The argument is that investors always have somewhere to turn as long as they are prepared to rebalance their portfolios.

Anna Lees-Jones, who manages M&G&#39s £1.3bn corporate bond fund, says: “We have always said portfolios are too heavily weighted towards equities. Even now, the latest figures I have seen show that pension funds are almost 80 per cent in equities. That must come down. But there is a lot of retail money coming towards corporate bonds now and that is a shift for the better.”

But IFAs face a dilemma in deciding whether to advise clients to rebalance their portfolios when bonds are so expensive.

Chartwell Investment Management director Patrick Connolly says: “It needs to happen but in an ideal world it would not be now. However, there is no argument for investors to hold inappropriate asset classes simply because they are cheap. At least investors will have better balanced portfolios.”

But gilts universally get the cold shoulder. IFAs say their rates are too low, with short-dated versions offering only 3.5 per cent. Ten-year gilts will yield around 4 per cent a year.

New Star, which bought more than £1bn worth of fixed-interest funds from Aberdeen Asset Management this month, points to other unattractive areas.

Marketing director Rob Page says: “High-end investment-grade bonds are not offering much value but, with UK corporations tightening their belts and paying off debt, we believe the lower end of that universe and upper high-yield bonds offer compelling opportunities.”

Less compelling is the argument for index-linked bonds. Thousands of investors are set to lose cash when bonds mature this year but providers are still offering products with downside gearing.

Most of these bonds are now shunned by IFAs but the proportion of those sold without advice is currently around 70 per cent.

Where should investors turn? Hargreaves Lansdown says equity income funds are essential in most portfolios as they yield more than cash and most bonds, as well as providing growth. On a 10-year basis, it argues that investors should increase their exposure to this sector.


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