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Investment Times

Bond markets – a spectre of risk

| 24 December 2015 | A A A
Bond markets – a spectre of risk

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

Almost seven years have passed since the Bank of England slashed the UK’s base rate to 0.5%. For much of the period since many commentators have called the imminent start of a ‘bear market’ in corporate bonds, yet their prices sit pretty much exactly where they were at the end of 2007.

Bonds issued by the British government (‘gilts’) with 10 years until maturity have a yield of about 1.8%. Given the government aims to devalue the pound in your pocket by 2% per year (via its inflation target), this feels like an offer to lose money over the long term. It can only really sound attractive to people who are afraid of something far worse happening to their capital.

Meanwhile, bonds issued in sterling by quality ‘investment grade’ companies offer yields closer to 3.8%. This is pretty much 2% more than 10-year gilts, and in a world of low inflation, low interest rates and moderate economic growth this looks to be an acceptable if unexciting yield. More enticing yields can be found in areas such as high yield bonds and emerging market debt, but these generally carry extra risks.

The main concerns for corporate bond investors are inflation, interest rates, ‘default’ and their ability to trade when they wish to, known as ‘liquidity’. In the UK at present there is little fear of inflation, with the government’s preferred measure (the Consumer Prices Index, or CPI) marginally negative and few commentators ready to predict notably higher levels anytime soon.

The UK economy, and to a large extent the global economy, remains in recuperation mode following the global financial crisis. Consequently, there is little concern about interest rates rises in the near future either. The market currently suggests there is little more than a 50% chance of any interest rate rise at all in the UK next year (beware, ‘the market’ can be horribly complacent sometimes). Even when interest rates in the UK do start rising, it is likely to be a slow rise rather than any sharp movement upwards.

Company managements have also been given plenty of opportunity to refinance their businesses at relatively low interest rates for many years out into the future. This means the likelihood of these companies failing to pay the interest due on their bonds on time or to repay investors when the bond matures (the risk of default) can also be deemed lower than in the past.

Corporate bond investors, generally, are therefore relatively sanguine about inflation, interest rates and default risks. However, this does not mean risk has vanished.

One area of concern in the corporate bond market is ‘liquidity’, which reflects how easily investors can buy or sell bonds at close to the official quoted price. Companies often have a large number of different bonds trading at any one time. This means trading volumes can be low, which means less liquidity. As demand for income has increased, and private investor demand for corporate bond funds in particular, the ability to trade these corporate bonds has reduced. This is at least partly a result of regulatory changes introduced since the global financial crisis, which reduces the willingness of investment banks to buy corporate bonds should private investors wish to sell. In extreme circumstances, where many investors are selling, it could therefore be difficult for investors to find a buyer resulting in the bid/offer spreads on bonds widening significantly.

Arguably, the higher than usual differential between the yield on corporate bonds and the yield on government bonds reflects this concern. That is, investors are paid extra to take this risk. However if liquidity really dries up, and investors can only sell with a high cost, they may quickly conclude the extra yield was not sufficient compensation.

On balance, we view sterling investment grade corporate bond yields as acceptable, but it is increasingly important to have an experienced hand on the tiller. We maintain a preference for ‘strategic’ funds where managers have more flexibility on how they handle future bond market conditions. Our favourite strategic corporate bonds fund feature on the Wealth 150.

The value of investments can go down in value as well as up, so you could get back less than you invest. It is therefore important that you understand the risks and commitments. This website is not personal advice based on your circumstances. So you can make informed decisions for yourself we aim to provide you with the best information, best service and best prices. If you are unsure about the suitability of an investment please contact us for advice.