Last time we reviewed high income funds we warned that a crunch was looming and that investors should sell. And it’s happened as we expected.
The credit crunch that started in the US spread worldwide, causing investors to fear losses on anything other than copper-botttomed investments. So they have sold out of anything with perceived risks attached, and that includes fixed interest bonds issued by lower-rated companies or governments.
At the same time they have piled into the safe haven of bonds issued by government like the UK, the US, Germany or Switzerland. So whereas you can now get a yield of 8% from high-yield corporate bonds, you get just half that if you lend to the UK government.
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Two year gilt yields are below base
Over the past six months, prices of funds investing in high-yield bonds have fallen by up to 10% while prices of top-quality government bonds have risen slightly. The ‘flight to safety’ has been a stampede of such huge proportions that you now get less interest on a two-year government bond than the base lending rate.
In the US, the Federal Reserve rate is 3% but two-year government bonds yield only 2%; in the UK, the Bank of England base rate is 5.25% but you get just 4% on a two-year government bond. Since you would normally expect to be rewarded for committing your money for a longer period with a higher interest rate, the current pattern of rates is an aberration caused by the credit crunch panic.
With inflation at 3%, it makes no sense to invest in bonds that pay you 4% before tax, but at the moment it makes no sense to buy funds yielding 7% or more because the climate of fear means prices could fall further.
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The F&C High Income fund stands out
The table shows the performance of our selected high income funds, but we have not recommended them as a buy for over a year. The only fund to do reasonably well has been F&C High Income, which doesn’t invest in high-yield fixed interest markets but generates an extra income by holding blue chip shares and writing options against them - a profitable strategy in falling markets.
AXA Framlington Pan European Bond has suffered both from the strength of sterling and from an even bigger shakeout in European fixed interest markets.
How our selected High Income funds have performed
| Fund | Gross yield | 6 months | 1 year | 3 years | 5 years |
| Aegon High Yield Bond | 8.1% | -5.9% | -7.6% | +6.0% | +38.1% |
| AXA Framlington Pan European Bond | 7.3% | -9.9% | -13.7% | -0.1% | +21.6% |
| F & C High Income | 7.8% | 0.0 | +1.8% | +18.5% | +34.3% |
| New Star High Yield Bond | 7.9% | -7.7% | -10.0% | +2.2% | +29.8% |
| SLI Higher Income | 8.2% | -7.9% | -9.4% | +5.4% | +40.0% |
| Sector Average | 5.6% | -3.5% | -6.2% | +3.7% | +32.0% |
*Including reinvested net income. Data to 3/3/2008. Source: Financial Express
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Due for a change, but when?
January 2008 was the worst month for fixed interest markets so far, with high-yield bonds falling by 4% while top-quality government bonds rose by 2% during the month- an exceptionally volatile performance from what should be quite boring investments.
And though common sense says the tide has to turn at some point - after all, most of these high-yield bonds are issued by companies that will go on paying their interest- few investment managers are saying it’s time to buy.
The sector that is most likely to recover first is ‘investment grade’ corporate bonds, which pay lower interest at about 5%. Because they have investment grade ratings, these bonds are far less likely to suffer defaults than higher-yielding bonds, but at present pay interest at about 2% more than government bonds.
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Two funds for 2008
The funds in our table are all higher-yielding ones, which may start to recover later this year. In the meantime, two funds investing mainly in investment grade corporate bonds that look likely to recover quicker are Old Mutual Corporate Bond and Invesco Perpetual Monthly Income Plus.
Stephen Snowden, who manages the Old Mutual fund, has an excellent track record. He suffered a performance blip at the end of 2007 but has repositioned the fund in higher-quality bonds, and is confident of better results in 2008.
At Invesco Perpetual, Paul Causer and Paul Reed are two of the most successful fixed interest managers, and their Monthly Income Plus fund also benefits from having a small percentage of the assets (currently 15 %) in high-yielding shares managed by Neil Woodford.
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Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
