I have a client and I know that their portfolio is currently under-exposed to corporate bonds. However, I feel reluctant to put their money into an asset class that looks highly valued, purely for diversification purposes. What should I do?
BEn YEarsley, Hargreaves Lansdown
I wouldn't put it in. Why not leave it in cash? Cash is giving you 4.5%, while investment grade corporate bonds are only giving you 5.5%.
You are getting a tiny bit less on the reward, but you're not taking any risk for it. You can then use any dips in the market as a buying opportunity. This could be when interest rates rise, which they are likely to do over the next year or two.
If you think something is over-valued, I don't know how you would justify putting it in a client's portfolio. How can this be "Treating Customers Fairly"? Cash should be an adequate diversifier. Cash has no correlation with anything. Corporate bonds are a different investment decision to equities. Even if equities are slightly over-valued, there is a long-term case - dividends rise, inflation increases and these things help equity prices. Fixed income is the opposite. Rising profits do not increase the value of a bond. The price goes up and down with interest rates and inflation.
I don't think there is much value in investment grade bonds at the moment. I don't see why you would buy investment grade bonds yielding 5.5%, when gilts yield 4.7%. Of course, it depends on the client profile. If you did need to invest in a corporate bond fund, I would look at the Artemis Strategic Bond fund run by James Foster. It is not tied into investment grade bonds and that type of fund should be able to generate value. Any pure investment grade fund will struggle.
Rob Burdett csam
If we are looking at corporate bond funds, we try to find flexible total return type funds. These are not necessarily Ucits III type funds, though we will be looking at those in our next review. Many were launched possibly 18 months too early as corporate bond funds have only really started to lose money this year.
Aegon has recently launched an investment grade, sterling-hedged global corporate bond fund. This means the investor is getting good quality bonds with little currency risk. It is an interesting product.
There is certainly a question over why you would leave money in bonds. But when interest rates go up, it is best to look for managers who have a proven ability to use duration risk - someone like Phil Roantree at New Star. His track record shows that he has been pretty active on duration.
We are always looking for flexibility. Invesco Perpetual's income fund is well known, but it has a Dublin fund that is more flexible and makes greater use of duration. It also uses options to synthetically adjust duration.
There is a case for not including corporate bonds at all. If you believe the economy is slowing, gilts are just as attractive. Spreads are still quite low. Managers are also looking for a high degree of covenant protection. Leveraged buy-outs are a problem. The bonds are immediately down-graded and up to 20% can be wiped off the capital. This is a big risk, but widely known and the best managers can try to avoid it.
john husselbee north investment partners
It all depends on the type of portfolio you are trying to create and whether you have an income requirement or not.
If you do, it makes sense to have an exposure to fixed income. You just have to decide what flavour you are looking for. Do you want duration risk? Do you want short/medium or long dated? Do you want credit risk?
The environment has been favourable for taking credit risk because interest rates are low and the additional spread is attractive to investors. But a lot of this has been taken out and corporate bonds are certainly not as attractive as they were two or three years ago. More people are looking at high yield to get higher income.
So, fixed income is the natural home to gather income. You can mix this up with some income from equity income to get a blend.
If, on the other hand, you are thinking about total return funds that don't have an income requirement, the answer would be slightly different. In this type of fund, you look for the best opportunities and invest there. In terms of corporate bonds, the direction of interest rates is likely to be up. We should continue to believe this until the Fed indicates otherwise. Interest rates in the US have been as low as 1%, but are now back to the middle of the range and could go higher. These things do not generally happen in a linear fashion, however. We are back in an inflation cycle - central banks like inflation cycles because limited inflation erodes their long-term borrowing. Therefore, it is not my chosen asset class.
The diversification benefits could be realised from other asset classes. Generally, you invest in bonds for preservation of capital and yield. If it is not preserving capital and not generating a decent yield, then it's not doing its job.
Paul Bruns and Elaine Parkes
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