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Invest in corporate bonds?

Investment | Fixed Interest Helpful? 5

Asked by winger14, submitted 13 January 2012.

Open Quote I know the bottom of the interest rate cycle is not normally a good time to invest in corporate bonds but in the absence of a sensible interest rate elsewhere and the current uncertainty in the stock market I feel I must consider this.

I assume a collective corporate bond fund would provide less risk than corporate bonds in individual companies, and wondered if they also keep pace with increases in interest rates by purchasing new bonds at higher rates when current ones expire, rather than than solely adjustments in the market price ? I also assume there is no guarantee on what price you will get back with a collective fund whereas with individual corporate bonds you know you will get your original money back if you hold them until maturity.

Would you mind also telling me if there are any investment trust equivalents of corporate bonds funds please.
End Quote

Answered by Justin on 05 September 2012

The key factors that affect the value of fixed interest investments like gilts and corporate bonds are the likelihood you'll receive interest and get your money back at redemption (called 'credit risk'), interest rates and inflation.

As you mention, interest rates matter as when bonds pay higher rates than savings accounts demand is likely to rise, pushing up prices, but if interest rates rise the benefit will be reduced so bond prices could fall. Inflation affects the future value of interest payments and return of capital at redemption (i.e. the money you've loaned the company/government), high inflation means this money will buy less in future reducing the attraction of bonds, hence their price.

Markets don't care so much about current interest and inflation rates, as what will happen in future. So it's all about trying to second guess what will happen over coming months and years.

Fund managers can help by diversifying across a number of bonds, which should reduce risk. But where they can really add (or destroy) value is their ability to take advantage of interest rate and inflationary expectations, as well as trying to snap up undervalued bonds where the market's overly pessimistic about a company's credit risk.

An important point here is something called 'duration' which basically measures a bond's sensitivity to interest rate movements (although the concept more or less holds true for inflation too). Bonds with a high duration are more sensitive to interest rate and inflationary movements, usually because redemption is a long time away and/or interest payments are low. Whereas these factors will have less impact on bonds with a short duration, as there's less time until redemption and/or more money is returned sooner than later via high interest payments.

In simple terms, if you think interest rates/inflation will rise over time then bonds with a short duration might do better. Whereas longer duration bonds may better suit a climate of falling interest rates/inflation.

Of course, in practice it's not this simple (which is why I'm not a bond manager!), but the above are the fundamentals of bond investing.

Do managers add value? Well, as usual, some do but most don't. Buying individual bonds yourself saves fund manager fees and provided the company issuing the bond meets its obligations you can work out exactly what you'll receive until redemption - something you can't do with bond funds.

The managers who tend to add most value are those who have a free reign on where they can invest (typically 'strategic bond' fund managers), although this might increase risk if they get it wrong.

If interest rates rise then new bond issues will likely pay higher rates of interest, but bond managers will have to sell existing bonds (whose price may have fallen) to buy them, so no net gain really.

Investment trusts were historically a tax inefficient home for corporate bonds as interest was hit by a high rate of corporation tax, whereas unit trusts holding more than 60% of the fund in bonds paid no tax on interest. Rule changes in 2009 bought them on a par with unit trusts, but we've yet to see new launches taking advantage of this. However, there are a handful of trusts based in the Channel Islands (historically to avoid the tax disadvantage) including New City High Yield, City Merchants High Yield and Invesco Leveraged High Yield.

Hope the above helps.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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