Look before you leap into the bond market

They may have a 'safe' image but bonds can still be risky, warns David Prosser

Corporate bond funds are supposed to be the medium-risk option for investors who want to move their cash out of the building society without all the risks associated with shares. But even medium-risk assets can sometimes turn out to be the wrong option for cautious investors.

Corporate bond funds are supposed to be the medium-risk option for investors who want to move their cash out of the building society without all the risks associated with shares. But even medium-risk assets can sometimes turn out to be the wrong option for cautious investors.

This is the dilemma for millions of investors who have just one more month to use this year's £7,000 individual savings account (Isa) investment allowance. Although the stock market has continued its slow recovery over recent weeks, many remain nervous about buying shares, following several years of disastrous returns. Research from fund manager New Star suggests that just one in 10 investors is prepared to consider buying stock-market-invested funds. Even residential property is a more popular option, despite persistent concerns that the housing market has slowed considerably.

Instead, many investors see funds that buy corporate bonds and other fixed-income assets as the best home for this year's Isa allowance.

"Investors are definitely leaning towards fixed-income funds," says New Star marketing director Rob Page. "This might seem surprising given the strong performance of equity markets, but investors are still drawn to the greater security of bonds."

But while bond funds have traditionally been regarded as a halfway house between cash and equities, the asset class could be much more risky than most investors realise.

In theory, because bondholders must be repaid before shareholders when companies begin to struggle, the sector as a whole should be more secure. But corporate bonds can still post disastrous returns, as investors in failing companies such as Enron have discovered to their cost.

Different corporate bond funds carry different risk characteristics. At the low-risk end of the scale, funds invested predominantly in gilts and other government bonds are the safest bet.

Blue-chip corporate bond funds, which invest in debt issued by large companies, are more risky, but should still be relatively secure. High-yield bond funds invest in less financially strong companies and are more volatile.

Some analysts believe now is the wrong time to be getting into any part of the sector. The latest Barclays Equity Gilt Study, one of the most widely respected pieces of investment research in the City, says bonds are a risky bet right now.

Author Tim Bond last week warned that high demand for bonds had lead to a serious reduction in the income that they pay in relation to their value. He now believes it will be difficult for investors to earn positive returns from bonds, even if they reinvest the income they receive.

Financial advisers are therefore wary. "The feeling among the product providers we talk to, even corporate bond fund managers, is that they favour equities over bonds right now," says Anna Bowes, head of investments at independent financial adviser Chase de Vere.

Patrick Connolly, a partner at independent financial adviser John Scott, is also concerned. "Most people are still sitting on their hands as far as the stock market is concerned," he says.

Even fund managers who are paid to promote corporate bond funds are currently pessimistic. New Star runs several large bond funds, but Rob Page warns: "At the gilts and investment-grade end of the market, bonds are susceptible to interest-rate risk and we are more cautious."

New Star's bond team is happier with investments in high-yielding bonds. But Page adds: "It's crucial to understand that corporate bond funds are not necessarily lower- risk than equities - it really depends on the type of bond that you buy and the economic environment."

That's not to rule out bond funds altogether. All investors need to build balanced portfolios of assets, with exposure to different types of investment based on their own attitude to risk and objectives. For income-seeking investors, as well as those who need to diversify out of equities, bond funds may still have value as a long-term holding, though they're not the only asset offering middle-of-the-road risk.

In other words, while investors are entitled to a new Isa allowance each year, entitling them to shelter £7,000 of investments from tax, it's important not to see each Isa as an unrelated purchase.

Financial advisers tip several funds in particular. Bowes recommends Old Mutual Corporate Bond as a good basic fund investing in blue-chip companies. Alternatively, she likes Threadneedle Asset Management's Strategic Bond fund, which invests in a blend of government bonds, blue chips and high-yield issues.

Alternatively, Connolly suggests Legal & General's Fixed Interest fund or Schroders Gilt & Fixed Interest.

"We prefer gilts and good-quality bonds right now, because high-yield bonds are moving too closely in line with equities," he says.

Another option is to look for a fund that specialises in identifying companies where finances are improving. All companies' bonds are evaluated by ratings agencies such as Standard & Poor's and given a measure of creditworthiness. If a company's rating improves, bondholders get a fillip.

Fidelity Investment says about 40 companies moved up to investment-grade ratings last year, immediately producing extra demand for their bonds. As the finances of companies such as BSkyB and Vivendi improved, the price of their bonds rose steadily.

Ian Spreadbury, Fidelity's senior fixed-income portfolio manager, says: "Thorough in-house analysis has enabled us to identify a number of those issuers prior to rating agency action and our portfolios have benefited accordingly."

The leading corporate bond funds returned around 10 per cent last year. But Fatima Luis, a bond fund manager at Foreign & Colonial, says performance is likely to be less attractive this year. "If you're expecting to see these kind of returns repeated, you're going to be disappointed."

ALTERNATIVES TO BONDS

Investors looking for a halfway house between cash and the stock market could opt for guaranteed equity bonds and funds. These offer exposure to the stock market but cap the losses investors can incur. In return, investors accept that they will not get the full upside of stock market gains when shares perform well.

Anna Bowes, of Chase de Vere, likes cautious managed funds and distribution funds. Gartmore Cautious Managed invests in a mix of assets, so that investors get exposure to high-return equities but have bonds to fall back on. Distribution funds are run similarly, but with investment limits in each asset class. Patrick Connolly, of John Scott, suggests funds that invest in commercial property. "One advantage of this asset class is that it has a very low correlation with other types of investment."

This means commercial property prices do not tend to fall at the same time as the value of other investments, which makes the sector a strong hedge.