GMP Independent Financial Advisors LLP

Fri, 22 Jan 2010 16:41:52 GMT

The average sterling corporate bond fund returned 16% in 2010 – not the kind of performance anyone would expect from the sector in normal circumstances, but corporate bonds had seen unprecedented falls. Furthermore, there were signs momentum was slowing, as the sector rose just 0.1% in December. Performance ranged from +3.4% to -2.2% between funds.

Most now consider the sector at least fair value and some are even suggesting the good times are behind it. The sterling corporate bond index fell 1.05% in December – more than that of the dollar or euro indices – while equity income managers are pointing out the dividend yield on some companies is now higher than their corporate bond yield.

For asset allocators that is likely to ensure a preference for equities, which offer the potential for greater capital growth. Certainly retail investors showed a marked preference for equities in November, with corporate bonds only the fourth best-selling sector, well behind the UK All Companies, Cautious Managed and Unclassified sectors.

Income investors can still generate a reasonable yield on corporate bonds. At the moment, yields on the majority of sterling corporate bond funds vary between 4% and 6%. While this may not look attractive compared to most equity income funds (which are paying a similar level of yield), it is attractive compared to gilts and cash.

The worry is that capital values will drop (and yields rise further) when corporate bonds lose the artificial support of quantitative easing. This issue is not as pressing as it is for the gilt market, but it remains a concern for bond managers. There is also a lot of issuance to digest still as the banks continue to tighten lending so companies are looking to capital markets to raise funds.

2009 was a stunning year for high yield, with the sterling high yield bond sector up 47.37% – a rise that puts it ahead of the majority of equity sectors. It continued its run of form in December, rising 3.2%. Yields in the sector are still attractive with most funds yielding between 7% and 9%. The strategic bond sector was up 23.9% for the year.

2010 contains a lot of unknowns for corporate bonds and it seems unlikely they will match last year’s level of performance. There are almost as many interest rate predictions as there are analysts, though few see rate rises in the developed markets for at least a year.

Spreads are still wide relative to history, but these are unusual times. Investors are compensated for downgrade and default risk, though the key question is whether it is enough. Duration will also be an issue. Many managers have protected themselves by going for shorter-dated bonds, but longer-dated bonds are now offering a significant uplift in yield. Getting this call right will be key. Ultimately, it is not the year to be in the hands of an amateur.

To find out more about our Investment Portfolios, please call Mark or Clare on 020 7288 6400

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