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The return is not enough for many bond investors

UK corporate bond funds are having a rough time of it this year. CGU&#39s monthly income plus fund, which was once the best performer in its sector, has gone down by almost 10 per cent in the past 12 months, while most of its rivals have not seen much better luck.

Much of the problem has been caused by the poor performance of preference shares, which often make up a sizeable portion of corporate bond funds. In the case of CGU, preference shares make up around 17 per cent of the fund, which fund manager Mark Gull believes accounts for its poor delivery.

He says: “Historically, the fund had a much higher holding in preference shares. We reduced that weighting but obviously not quite enough.”

Gull took over the management of the fund from Hugh Everett in March.

CGU&#39s results have sent alarm signals through the IFA community, with many of its clients investing in the fund. Almost all IFAs have put the fund on hold for new money, while others are starting to go one step further and advise clients to move elsewhere.

Chase de Vere is writing to clients to explain the fund&#39s poor performance and allay any immediate concerns.

Investment adviser Justin Modray says: “We have been concerned about the fund since the change of fund manager. We are not recommending people to jump ship yet but we are certainly putting no new money into it.”

Modray believes another factor in the poor performance of the corporate bond sector may be legislative changes made by Chancellor Gordon Brown in this year&#39s Budget.

A fund cannot now be classified as an income fund if it has more than 49 per cent of its holdings in preference or convertible shares. In such a case, the fund would be classified as a dividend fund, losing its eligibility for Isas. Despite the recent poor performance of preference shares, they are usually the main factor when a corporate bond fund delivers strong returns.

For an investment that is typically associated with low risk, it has been a shock for investors to discover that their initial investment could be worth much less after one year. A £10,000 investment in CGU&#39s fund a year ago would now be worth only £9,020.

Bates Investment senior analyst James Dalby sayspeople need to be aware that corporate bonds can carry risk. He says: “In the past, people have perceived corporate bond funds as very low risk but they are subject to interest rates, so they clearly do carry an element of risk. Part of their poor performance recently has been due to perceptions that interest rates are still going to rise.”

As bad as the figures look for the UK corporate bond sector, now may be the time to start getting in rather than out. Interest rates may goup one more time but there is little doubt that we are coming to the peak of the interest-rate cycle. With the kind of performance the sector has witnessed over the past year, it would seem that the only way left to go is up.

For those investors who have been badly shaken by the past year&#39s corporate bond experience, switching funds could turn out to be a costly business. Although CGU investors can switch free of charge to the company&#39s other funds, there will be transfer fees if they move out of the CGU investment umbrella.

Perhaps the most cost-effective decision would be a switch to the NU corporate bond. As a Cat-standard fund, there is no transfer fee no matter which investment house the switch comes from.

Compared with its CGU rival, the NU corporate bond fund is a relative star. Over one year, it is rated ninth in its sector and is one of the few corporate bond funds to have seen a positive return over the past year. NU&#39s Cat-standard higher income plus is another fund that carries no transfer fee.

For those that decide to look for alternative sources of income, the UK equity income sector is producing far more promising capital growth, although admittedly at higher risk. The downside is that income is typically only 3 per cent compared with around 8 per cent in the corporate bond sector.

A further income option would be a high-income stockmarket bonds, such as the those marketed by Abbey National and Eurolife.

Plan Invest director Michael Owen says: “The problem with high-income stockmarket bonds is that you are putting your client into an 8 per cent income environment but with a much greater risk to capital. There are not actually that many low-risk income options outside corporate bonds.

“We would advise people to stay put for the revival in the bond market, which I am sure is due. Most important is to keep a spread of risk in the client&#39s portfolio so that you are not just invested in corporate bonds.”

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