Scotsman article: The name's bond – corporate bond, and they are gaining in popularity

02 May 2009

WITH interest rates at all-time lows and gilt yields being squeezed, many investors are turning to corporate bonds for income and potential capital appreciation.

However, the stampede has triggered fears that this is a yet another bubble which will inevitably burst.

Companies are still focusing much of their attention on reducing debt (deleveraging) while some bond holders (eg hedge funds) continue to be forced sellers of the asset class. While investment-grade bond prices have risen marginally of late, the market continues to be supply driven.

Investment grade bonds do appear to be cheap at the moment.

The disparity between corporate bond yields and lower risk government bond yields (known as credit spreads) is at unusually wide levels, up to 5 per cent. This is because investors are currently demanding to be heavily compensated for accepting the additional risks of buying commercial credit.

However, the bond market is currently pricing in assumed default rates of around 40 per cent, but default rates since 1970 have not exceeded 5 per cent. While we are in unchartered waters, surely there is too much pessimism here.

As corporate bond capital values have fallen, their corresponding yields have increased to very attractive levels, particularly when compared to cash and gilts. Moreover, companies seeking funding via new bond issues are having to promise much more interest than would have been the case a year or so ago. Some individual bond stocks are now yielding as much as 10 per cent.

That bond defaults will increase is not in doubt. But the uncertainty as to the level of this attrition and as to which companies might fail means that there are definite opportunities in this sector. Selecting bonds issued by companies more likely to survive than not is crucial. The best means of buying such expertise and spreading the risks is by investing via a collective investment fund which invests in a wide selection of carefully chosen investment grade debt. A

nother risk associated with bond investing is that which would be presented by rising inflation and attendant higher interest rates. While this is not a factor at the moment, low interest rates, high levels of government borrowing and recent money printing measures (most notably quantitative easing) are likely to ensure that inflation will rear its head again in the not too distant future. Bond investment opportunities should therefore be considered a relatively short-term play – perhaps a year to 18 months.

Finally, corporate bonds should represent only part of a properly diversified portfolio, appropriate to all your needs – your attitude to risk, accessibility requirements and time horizon.

Paul Lothian is a director of Verus Chartered Financial Planners in Dundee.

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