There are many reasons for taking a closer look at fixed interest investments. For one, as we get ol...
There are many reasons for taking a closer look at fixed interest investments. For one, as we get older we naturally tend toward the more conservative, with a small 'c', which includes the way we manage our savings. After all, the stakes get higher as we get older because as our working years dwindle we are confronted with the prospect that lost savings can no longer be replaced.
Experienced investors also like to move the balance of their portfolios more towards cash or fixed interest assets at times of high stock market drama. Such 'flights to quality', as they are sometimes called, are rarely far behind when a significant market correction hits. Of course, the demand from private investors for income-generating products is also continuing to grow, especially as the proportion of those in retirement increases.
It is now a decade since Pep status was first granted to corporate bond funds, and their sales exploded, but many smaller investors are still missing a trick when it comes to making the most of this part of their portfolio. These days, a worthwhile corporate fund manager will be able to offer a range of fixed interest portfolios that can offer anything up to 10% pa or more for what, in reality, will still be a lower level of risk than the average With Profits or Cautious Managed fund.
As Gerry Slora, a senior financial adviser with City-based stockbrokers Keith, Bayley Rogers, explains: "What we often find is that even experienced investors who have spent years carefully tending personal share portfolios, pension and unit trust funds, suddenly lose the plot when it comes to locking in long-term lower risk returns. Investors need to realise that fixed interest investment covers a broad spectrum of risks and rewards and that getting the balance right is crucial.
"After all, whether you are retired or not, a potential shortfall of up to 10% a year in your fixed interest returns is a serious investment risk."
The flipside of the coin is that well managed corporate bond funds offering 10% pa after charges make an ideal halfway house for many investors. They offer under rewarded deposit investors an alternative to full on stock market investment and offer those reducing their equity exposure an opportunity to maximise their returns.
When the markets start to get stormy, moving to a high yield corporate bond fund and re-investing the income can offer 10% pa compound growth which, not surprisingly, many investors find an attractive option.
With such a choice of fixed interest products on offer, the real question comes down to understanding the risks involved. Many investors, for example, still mistake deposit accounts as being risk free when compared to the genuine investment risks presented by a corporate bond portfolio. But, while deposit accounts will always return your initial investment, the rate of return is subject to the risk of interest rate changes, while the real value of your deposit risks erosion from inflation.
If you consider that one of the most high-profile high street deposit accounts is currently advertising its 4% interest rate on television, you start to appreciate this risk a little better. Remember that a 40% taxpayer will have to sacrifice a further 1.6% of this before factoring in inflation, and that there might also be penalty charges to consider, and it is not a pretty picture.
The other risk to consider here is probably best described as 'marketing risk'. That is the risk that, once any deposit account provider has concluded a marketing campaign for a certain rate of return and taken its fill of new deposit funds, it is only a question of time before the rate is reduced.
As Slora observes: "Investment risk might mean that the return on a high yield bond fund can move about by a few basis points but the fund's manager is not going to stop pursuing the promised level of yield just because enough new money has already come through the front door. That's not the way banks operate."
The truth is that while corporate bond funds have so much to offer small investors, the risks attached have never been particularly well understood by either investors or their advisers. This is especially so with the relatively new high yield corporate bond funds.
Until quite recently even the best established of the industry's bond funds were reluctant to take on significant positions in high yield bonds, namely those of Standard & Poor's credit rating BB and below.
This was partly because of the perceived risk of what, until recently, was a largely US-dominated market. Quality UK and European high yield issues were few and far between.
These days the universe of quality high yield bond issues is significantly larger than it was two years ago. The huge investment into infrastructure undertaken by technology, media and telecoms companies such as Colt Telecom, BskyB and NTL has led the way, but activity is definitely on the rise in other industry sectors.
Meanwhile, the last two years have quietly seen the rise of a new corporate paradigm that has also helped swell the ranks of the high yield market.
Ironically, it is the pressure on modern management to deliver true shareholder value that has accelerated the growth of the high yield bond market from infancy only a few years ago to a healthy adolescence today.
We see high yield bonds as the most transparent fixed interest class and so have focused the Maximum Income Bond 100% on this sector. Because we have such strong credit analysis capabilities, and are a respected player in this market, we are able to meet the management of bond issuing companies and run extensive cash flow analyses of their businesses. We also look at what other companies might be supporting them in terms of ownership or orders so that we know exactly how capable a company is of making its bond repayments.
A look at the Sharpe Ratio figures confirms that high yield bonds are actually the most efficient asset per unit of risk, but detailed research is what enables us to keep the investment risk broadly in line with that of a Cautious Managed fund. Focusing on high yield bonds also means we have avoided the problems many managers have had with more volatile asset classes.
Corporate bond funds have come a long way in the last few years, but it seems clear even today that if a yield is too good to believe, it probably should not be. The key to finding the right manager is to look for one with an established track record in the market and a demonstrable research process.
Headline grabbing yields will still come and go, of course, just do not let a fund manager's enthusiasm for racy marketing speak distract you from taking a proper look under the hood.
William Russell is director of retail funds at RSA Investments
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