The last two months have seen panic in financial markets on a bigger scale than any time since 1974 and, as usual, it’s throwing up some good investment opportunities. The best is probably fixed interest bonds.
In a panic, investors flee to ‘safe havens’ and one is the bonds (or loans) issued by governments. After all, if the government can’t pay its debts, who can? The result of this lemming-like rush is that the return you get on such bonds has fallen to about 4.5%.
But at the same time investors have dumped bonds issued by companies, even big ones, so that you can now get a an income of 7% or more, even as much as 10%. Among them are the banks, which is a bit odd given that the UK government has ridden to the banks’ rescue. Indeed, under company law, a bank cannot pay a dividend on the preference shares the banks are issuing to the government until they have first paid the interest to investors in its fixed interest bonds.
That isn’t the only anomaly in the market. In normal times, the return you can get from ‘investment grade’ corporate bonds (those rated BBB and above) is usually only a little more than you get from government bonds. Today, it is 5% more - and the gap between the two hasn’t been this wide since the 1930s.
Effectively, what investors are saying is that yields need to be so high to compensate them for the risk that companies won’t pay the interest. But to justify current prices and yields, analysts calculate that two in every five UK and European companies that have issued investment grade bonds would have to go bust.
Default fears are too pessimistic
If you think through the implications of defaults on that scale, you get to an economic landscape like the 1930s, in which economies slumped and banks and businesses went bankrupt in droves. If you believe that is what’s going to happen, then I suggest you buy gold, because bank guarantees won’t be worth the paper they’re written on and the world really will be in total meltdown.
But in fact, I don’t think that will happen and nor do most analysts looking at corporate bonds. They point out that companies are, by and large, financially stronger than they were in the last three recessions: they have less debt and more cash. Moreover, though we will have a recession, the early action taken by the US and other countries means it is very unlikely to turn into a slump. The most likely scenario is that more companies will default on their loans but far fewer than is currently expected.
The consequence should be that when investors realise things aren’t quite so bad, they’ll buy up these bonds to get the higher income they pay. And the more central banks cut their short-term interest rates, the more attractive these 7%-plus yields will become.
Avoid the bad bonds
It’s important to distinguish between two different categories of corporate bond: investment grade, where the business is financially strong, and ‘sub investment grade’, where there are serious risks of default. Though yields on these lower-quality bonds are as much as 15%, they’re just too risky to buy now. So I’ve been looking at funds investing in investment grade corporate bonds issued by UK and European companies.
I’ve been monitoring the views of investment grade bond managers for the past six months. Some were already becoming optimistic then – too early as it turned out – but almost all of them now see great opportunities in the sector.
The average fund investing in UK and European corporate bonds is down 11% over six months; some are down 20%. This is just not good enough. Managers of bond funds are paid not to lose money, so they should have taken defensive action. I’ve selected two funds that have done a lot better than that by holding cash and switching to safer bonds. But I’m also including one fund that has done worse, because I rate its managers so highly.
Funds investing in investment grade corporate bonds
| Fund | Yield* | Return+ over 6 months | Over 1 year | Over 3 years |
| Invesco Perpetual Corporate Bond | 7.5% | -11.6% | -19.7% | -6.6% |
| M & G Strategic Corporate Bond | 5.5% | -3.5% | -1.8% | +1.9% |
| SLI Corporate Bond | 5.9% | -6.6% | -8.8% | -8.0% |
| Sector average | 5.7% | -9.9% | -11.1% | -10.3% |
* Before tax.
+ Including reinvested net income. Data to 10/11/2008. Source: Financial Express
Caution spared the worst
Richard Woolnough at M & G and Andrew Sutherland at Standard Life Investments remained relatively cautious until this summer’s crisis. So their performance numbers don’t look too bad compared with those of other funds.
At Invesco Perpetual, managers Paul Causer and Paul Reed turned positive in the Spring, and their fund has suffered more in the panic as a result. But their long-term record with this fund is so good that it seems likely they’ll do as well or better than anyone else once we head into an upturn.
One measure of how cautious a corporate bond fund manager is is the percentage of the assets they hold in bonds rated A or higher. Invesco Perpetual holds 50% of its investments in this class, M & G 60% and SLI 75%. The counterpart to this is that bonds rated BBB, where fears of defaults are highest, will show the biggest gains when investors become more confident. Invesco Perpetual hold 35% in BBB rated bonds; M & G 25% and SLI 20%.
It’s an investment commonplace that falling interest rates are good for fixed interest investors. So unless we really do have a doomsday scenario, these funds should produce good returns over the next year or two. As the big government financial rescue packages work through the banking system, interbank lending rates should fall and banks - which are big investors in bonds – will then have a strong incentive to switch money into this sector. Despite the uncertainties, I therefore expect these funds to have one of their best years in 2009.
