With property appearing to be running out of steam, the equity market still volatile and investors weary of the paltry returns on cash, investors could do worse than make a high yield bond fund their Isa choice this year.
The Bank of England lowered base rates in early February, to the relief of homeowners and businesses. Beleaguered savers, who were already battling to extract a paltry return from their savings, were less enthusiastic. But where do they place their money if they are unimpressed by the 3% on cash deposits?
The property market looks to be peaking and, after three years of falls, the equity market seems to be only for the brave.
It comes as no surprise then that investors are turning to bonds to help boost their returns. This move sits very comfortably with the drive to invest for income, which is expected to be a strong theme, not only in this season's Isa sales, but also for the foreseeable future.
I believe investors are right to be looking for income products in today's market. We have been advocating for some time that we are now in the latter stages of a bubble cycle. Companies are having to undertake belt-tightening and balance sheet restructuring in order to correct the excesses of the boom and enhance profitability going forward. In a leaner growth environment income generating assets are likely to be viewed favourably by investors.
The measures taken by companies to strengthen their balance sheets and make efficiency savings play right into the hands of the corporate bond investor. Bond investors are attracted to predictability, not the promises of jam tomorrow that an equity investor wants to hear.
If companies begin to focus on core competencies, improving their cash flows and rationalising their business, it is music to the ears of a corporate bondholder since these measures should help to improve the interest cover on the company's debt, helping to lower the credit risk on its bonds.
Any reduction in credit risk should help narrow the spread on corporate bonds and raise their prices. This effect is particularly felt at the high yield end where credit spreads are wider, offering the possibility of larger capital gains. This was seen in the last quarter of 2002, when the high yield bond sector rallied on the prospects of improving credit quality and the hope that we have seen the peak in defaults.
Paradoxically, the sheer scale of defaults and company collapses over the last couple of years may well have been a useful pruning tool. The weakness of the financial markets and global economy has tested the strength of many companies over the last few years.
Those that failed have followed the harsh evolutionary process, while those that have survived should be stronger and better able to reap the benefits of any economic upturn. This encourages me to believe that we have passed the peak in defaults, as much of the deadwood has already been removed.
However, I think bond investors have to be careful where their bond fund is positioned. The very high yield debt looks too risky, while top end investment grade bonds, following strong performance in the last few years on the back of falling interest rates, are starting to look expensive.
So why am I anxious about the very low rated end of the high yield bond sector? I believe the very low rated issues are stuck between a rock and a hard place: the hard place being a subdued economic environment that is unlikely to offer much in the way of top line revenue growth in the near future; the rock being the closed door of the capital markets as weaker companies find banks are selective in their support and bond markets are wary of backing issues from the more risky companies. I believe this more distressed debt is not worth the extra risk for the increase in yield it might bring.
Conversely, that doesn't mean it's better to be in the top end of investment grade debt either. Government bonds and highly rated corporate paper may face less in the way of credit risk or default, but they are currently expensive.
Their lower yields also make them more susceptible to interest rate risk. Long-term interest rates are already low and, although there is scope for some further shaving of base rates, the deteriorating fiscal positions of most western governments paints a picture of rising yields, as governments have to compete for funds in the market.
The tax giveaway by George Bush in the US and the fiscal stabilisers and increased public spending in Europe are seeing a burgeoning of government bond supply. Although there is demand enough to absorb this supply, it is likely to limit further outperformance from government bonds.
This will put added pressure on high-grade corporate bonds that do not have the wide spread over government bonds to provide protection from interest rate risk. It is also delusory to think that investment grade bonds are bullet proof.
The defaults of Enron and WorldCom show that default risk can be lurking amongst perceived safe issues, highlighting the need for careful security analysis and diversification in any bond portfolio.
Indeed the problems surrounding the pensions deficits at some of the larger companies underline the fact that investment grade debt can be just as susceptible to credit problems as the high yield sector. The unfolding accounting debacle at Ahold, the Dutch supermarket group, only serves to emphasise this point.
I believe the 'crossover' region, the low end of investment grade and top end of high yield, offers some of the best value in the current market. A hybrid fund that invests in both investment grade and high yield bonds, with some flexibility to move between the two groups would probably be the wisest option.
This allows the fund to capture any favourable movements in both interest rates and credit quality, as well as offering increased diversification.
The ravages of the equity markets over the last three years have opened investors' eyes to the need for diversification in their investments. Spreading your investments across a variety of assets should help to spread risk and capture reward. Most investors already have exposure to cash through their rainy day savings, and with around 70% of UK householders owning their homes, property is for many their biggest investment. Even direct equity ownership grew as a result of privatisations and market participation during the 1990s.
Yet retail exposure to the bond markets is still immature in its penetration of the hearts and minds of investors. Even at the institutional level there is growing recognition of the benefits of holding bonds.
The structural shift towards holding more bonds by institutions acknowledges the innate liability matching qualities of bonds.
Boots' decision to move all its pension assets into bonds now looks surprisingly prescient, while others have paid the price of sticking doggedly to too heavy a weighting in shares. With an ageing population and companies and institutions keen to match their pension liabilities, the structural shift towards owning more bonds is likely to be a long-term phenomenon and one that may be mimicked by private investors. This paints a favourable demand picture for bonds going forward.
Economic growth is predicted to be positive, if unexciting over the coming year. This should be sufficient to allow companies to grow earnings while still encouraging them to reduce debt levels and cut costs to enhance the bottom line. With inflation expected to remain low, the conditions exist for possible increases in corporate bond prices on the back of improving credit quality amongst companies.
However, in thinking about capital gains we ignore the most attractive element of a high yield bond fund; its income. High yield bond funds are offering substantially more income than a cash Isa with less of the risks associated with equities. The Government has indicated that the ability to reclaim the tax credit on the dividend payment from an equity fund held in an Isa or Pep will cease in April 2004. From a Chancellor who withdrew the tax credit on dividends in pension funds, the signs are not good that the Treasury will extend its largesse beyond the next tax year. No such deadline exists on the ability to reclaim tax deducted from interest payments, giving a big tax advantage to a bond Isa.
Property seems to be running out of steam, equities are still volatile and investors are weary of the paltry returns on cash. There are no promises in these markets, but investors could do worse than make a high yield bond fund their Isa choice this year.
Income generating assets will continue to be favoured by investors.
The peak in defaults has been passed as much of deadwood has been removed.
Low rated end of high yield debt will suffer from subdued economic environment and more wary lenders.
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