Bonds offer a good deal but not without risk

SAVERS have been warned against viewing corporate bonds as a panacea for their income woes after advisers raised concerns that many people underestimate the risks of investing in the sector.

Corporate bonds have been popular with cautious investors over the past two years as returns on cash savings have plummeted.

Record low interest rates mean the average savings account is failing to keep pace with inflation, which Mervyn King, governor of the Bank of England, recently warned could stay well above its 2 per cent target until 2012. And while interest rate rises could be on the cards over the coming year, higher interest rates won't automatically translate into higher savings returns.

Consequently the search for income is set to continue for some time, but for those unwilling to put their money at the mercy of stock markets, options are relatively limited. Corporate bonds are one solution, particularly for relatively cautious investors, and sales of corporate bond funds have been strong over the last year.

However while the risk of investing in corporate bonds is typically lower than that on equities and the income is more consistent, investors can still suffer capital losses.

Haig Bathgate, investment director at Turcan Connell, said: "In the short term they are likely to be less volatile but if we have a bout of inflation and a corresponding increase in interest rates, putting the credit risk to one side, investors could endure a significant capital loss on invested capital and possibly more than you might expect in equities."

This also applies to government bonds where a ten-year gilt is now trading on a sub-3 per cent yield, he added. "If inflation returns, investors could again bear large capital losses on their initial investments."

Risk is also determined by the chance of the company issuing the bond going bust. Investment grade bonds are issued by the companies least likely to fail, with the extra security offset by a lower return. At the other end of the scale, those issued by the riskiest companies are high-yield or "junk" bonds, paying a higher return but with a greater chance of the firm defaulting.

Investors still have greater protection in the event of a company failing, however, as bond holders are prioritised over equity investors when it comes to getting their money back.

Similarly, the income from corporate bonds is more reliable than that from equities because they pay out a fixed rate of interest.But the popularity of corporate bonds means the strong flow of money into them has reduced the income being paid in recent weeks, according to Adrian Lowcock, senior investment adviser at Bestinvest.

"Investors are being warned that there may be a bond bubble, which mainly relates to gilts but in some areas this is filtering through to the corporate bond market," he warned. "In this market investors should be careful and the best approach is to use an expert such as a bond fund manager to select the right bonds and one with the flexibility to move anywhere in the sector from the quality end to high-yield and find the opportunities which still exist in the sector."

Ken Taylor, managing director of Mackenzie Taylor Wealth Management, said some corporate bond unit trusts hold up to 300 individual securities, ensuring the risk is broadly spread.

"The key to good corporate bond investment is to seek out those managers with the greatest research capacity, as the biggest risk to investors is default," said Taylor. "History shows that the larger corporate bond investors tend to be the most successful, as they generally enjoy an advantage in terms of securing new issuance in addition to having greater credit research capacity."

Views on the outlook for corporate bonds are mixed. For instance, Bathgate is concerned about the potential impact of a gilts sell-off on companies issuing corporate bonds. "We think it likely the cost of funding for companies will increase on the back of gilts selling off, in turn increasing the probability of defaults increasing."

Logic also dictates that while interest rates are at their current record low there is a limit to how much income can be produced without taking risk. Interest rate increases are bad news for corporate bond investors and rates can only go up from here, a move that would put capital at risk.

However, that may not be for a while, according to Bathgate.

He said: "Bank of England governor Mervyn King coined the phrase 'morale hazard' where those with too much debt are bailed out at the expense of savers, but as the banking sector looks set to remain under pressure having to provision for bad loan decisions, and consumers are about to feel the impact of the austerity measures, the current position looks unlikely to change in the short term."

More optimistically, Taylor believes corporate bonds are currently a good long-term bet for investors due to benign inflation, low interest rates and, most significantly, a change in the cycle of money due to banks not lending. He recommended funds including the M&G Corporate Bond, M&G Strategic Corporate Bond and the Jupiter Strategic Bond.

A more recent corporate bond fund launch came in the form of the Alliance Trust Monthly Income, which has raised 35 million since its June launch.Rod Davidson, head of fixed income at the Dundee-based trust, told The Scotsman earlier this week that corporate bonds would continue to provide returns for investors. "Higher rated corporate bonds still offer value, especially given the emergence of the global economy from recession," he said.