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Making the grade

Stuck in the shadows throughout most of the bull market, it seems that corporate bonds could at last step into the spotlight, with spreads on investment-grade corporate bonds now appearing more attractive than during the dotcom crash.

Looking at performance statistics, there seems little to get excited about. The average fund in the IMA corporate bond sector is down by 7.2 per cent over three months and 11.6 per cent over 12 months. Average falls for strategic bonds and high-yield bonds over 12 months are 15 and 22.8 per cent.

Net retail sales of bond funds were only £137m in 2007 against £5.23bn for equity funds and £422m for money market funds.

However, the performance of corporate bonds amid the credit crunch appears to have defied logic. Until the last few weeks, investment-grade bonds had fallen by far more than high-yield bonds – the reverse of what should have happened, given that the issuers of high-yield bonds are more likely to go bust. However, the flood of investment-grade bonds sold on to the market by hedge funds and institutions, as they looked to escape huge levels of leverage, confused the issue.

Now high yields have taken a hit. The sell-off across the market has depressed the price, with phenomenal rates of company default now factored in. Fund managers and advisers point to a tipping point and say the attraction of bonds over the short and long term has never been so great.

Investec Asset Management co-head of fixed income John Stopford believes that investors could earn as much as 20 per cent a year in the corporate bond market in the next two years.

He says credit is trading at extraordinarily distressed prices, with the market pricing in a scenario where half of all high-grade companies will go bust in the next five years, 10 times the amount of investment-grade companies that went bust during the five years of the Great Depression.

Stopford comments: “As Nathan Rothschild famously said, ‘The time to buy is when there is blood in the streets.’ It is hard to miss the gore now sloshing around in the corporate bond market. This has, after all, been a credit crisis and credit is trading t extraordinarily distressed prices. There is the potential to generate exceptional returns for brave investors, even against a deteriorating economic backdrop.

“All the aspects are there. Investment-grade spreads are high and the yields are there, providing a good income of 15 per cent above Government bonds to compensate for those high figures of default risk. The pricing of high-yield bonds should see them deliver attractive returns, particularly in the next couple of years as the market recovers.”

Fidelity FIF extra income fund manager Ian Spreadbury says the attraction of high-yield bonds is widespread. He points to the European high-yield bond market which is yielding 22.7 per cent, with spreads of 18.5 per cent above government bonds.

Spreadbury says: “The beauty of high-yield bonds is that at times of stress in the economy or financial system, the income from a well constructed portfolio can sometimes offset any impact to an investor’s capital value.

“If we look at US high yield, a market with a lot more history than the UK or Europe, the best total returns come straight after peaks in credit spreads, reaching as high as 30 or 40 per cent on a year-on-year basis. If spreads over here come down slightly, investors with good name selection could see handsome returns on a 12-month horizon.

“High yield can also be an effective de-risking tool for equity portfolios. Adding high-yield exposure through an equity bear market can reduce portfolio downside while leaving open good upside potential.”

New Star head of fixed income James Gledhill believes that distressed prices have little to do with defaults but with supply and demand while the whole market has gone out of balance after the collapse of Icelandic banks and the impact on the leveraged loan market.

He says: “Leveraged loans are traditionally at the top of the capital structure and now they are being hit, leading to a sell-off which will also have an impact on the price of high-yield bond funds.

“High yields have the potential to offer 20 per cent a year over the next three or so years but investment-grade could offer a higher coupon for a longer period, so you could see returns there of 13 to 14 per cent over the next 10 years.”

Hargreaves Lansdown investment manager Ben Yearsley says the fire sale and market collapse have given investors the opportunity to avoid the high-yield market and hold investment- grade. He says: “There is no need to take the risk with high yield although it is unlikely the banks are going to allow a repeat of Lehman Brothers, given the impact that had on the market.

“High yields may offer stronger returns in the short term but investment-grade is likely to be near the 20 per cent a year mark for a longer period as well as a greater total return. There is a window for investors to capitalise by choosing the right funds.”

More investment news and analysis at: www.moneymarketing.


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