Sterling corporate bond funds for this year’s Isa? Advisers prefer strategic funds but offer some suggestions

10th March 2014

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Should you put the Sterling corporate bond funds in your Isa? Investment journalist Cherry Reynard examines the sector for Mindful Money and asks some experts for their recommendations.

The sterling corporate bond sector was largely flat in 2013 with the average fund rising just 0.6%. Investors gained the income, but lost some capital and the two balanced out. However, the picture was a little more complicated than it first appears. For taking the risk of corporate bonds over government bonds, investors are paid a premium (or ‘spread’). This spread will vary over time. The performance of corporate bonds is therefore influenced by the movement of the spread, and the price of government bonds. Government bonds sank in 2013 after the Federal Reserve announced it was to taper quantitative easing. Corporate bonds didn’t sink in the same way because markets decided they were less risky and narrowed the spread. However, this means that the amount of reward investors get for taking the risk of corporate bonds over government bonds is now at historic lows.

Longer term, the average fund in the UK Sterling Corporate bond sector has risen 59% over the past five years (to 5th March), compared to a return of 72.8% from the property sector, from the UK All Companies sector of 147.4%. Shorter-duration funds have tended to perform better recently as they have had less exposure to the prospect of rising interest rates. Also, a lot of corporate bonds are in the banking sector and these bonds have swung in and out of favour. The managers who have managed to call those swings correctly have done well. Old Mutual, Kames and M&G are the key players in the sector, with the largest funds.

When does the sector perform well/badly?

Investment grade corporate bonds are more closely tied to the price of government bonds than, say, high yield (or ‘junk’) bonds.

If government bonds are doing badly because interest rates are likely to rise, then investment grade bonds are likely to suffer as well. Equally, bonds do not tend to perform well in an environment of high inflation. The coupons on a government bond are fixed and therefore become less valuable if inflation is high. Generally, bonds will fare poorly at a time when economic growth is forging ahead and therefore may face some headwinds in the current environment.

How much of a portfolio for low/mid/high risk investor?

This will depend on an investor’s age and their requirement for income. Corporate bonds no longer look like a ‘safe’ option in the current climate, but they still offer some attractions for income-seekers. Funds generally pay an income of between 3.5% and 4.5%, higher than a bank account and higher than government bonds. Default rates – the likelihood of companies defaulting on their bonds and investors losing their money – are at historically low levels. However, they have had a strong run, interest rates are likely to rise and economic growth is expanding. Also a number of funds in the sector are very large and may suffer liquidity problems if sentiment turns against government bonds. They do not currently look like an attractive option for investors who have to grow their capital over time. A small weighting as a portfolio diversifier remains a sensible option.

Top 10 by performance (5 year – %) – Property sector

Old Mutual Corporate Bond – 119.3

Old Mutual Corporate Bond U2 – 118.5

Henderson Sterling Bond – 106.5

Baillie Gifford Investment Grade Long Bond – 102.4

Kames Sterling Corporate Bond – 89.3

Fidelity Institutional UK Long Corporate Bond – 89.2

Pimco GIS UK Long Term Corporate Bond – 84.2

BlackRock Corporate Bond – 83.8

L&G Managed Monthly Income – 83.2

Questions for investors to ask themselves

Do I want to generate a high income?

Do I want a manager who invests globally or just in the UK?

Do I want to minimise exposure to rising interest rates?

How large is the fund?

Do I want a manager who prioritises the highest quality companies?

Adviser comments and funds they like

Jason Hollands, Managing Director – Business Development & Communications, Bestinvest

“Bond markets face further volatility as interest rate expectations change and the prop of central bank asset purchases is slowly withdrawn. We are therefore cautious on fixed income and prefer strategic bond funds that are running with short-duration.

Our preference would strongly be to hold strategic bond funds rather than investment grade funds. Our top picks include L&G Dynamic Bond and TwentyFour Dynamic Bond.

“But if investors really do want to box themselves in to an investment grade fund, our choice is Invesco Perpetual Corporate Bond managed by Paul Causer and Paul Read. The fund invests primarily in sterling denominated, investment grade, corporate bonds and may also include some exposure to high yield bonds and non-sterling issues to increase diversification and improve overall returns. Historically where their convictions are high, the managers have been prepared to aggressively manage the interest rate sensitivity and the credit exposure of the fund.”

Patrick Connolly, financial planner, Chase de Vere

“We hold investment grade corporate bonds in client portfolios as they can provide steady income and some protection in an investment portfolio from stock market falls. However, we are concerned that many bonds look expensive and so prefer to get exposure through strategic bond funds where the manager has the flexibility to hopefully avoid the worst of any fallout across the fixed interest spectrum. The investment grade bond funds we recommend are the Fidelity Moneybuilder Income, Rathbone Ethical Bond, but we prefer strategic bond funds such as Henderson Strategic Bond or Jupiter Strategic B

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