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Is it time for yield-starved investors to consider corporate bonds?

Paloma Kubiak
Written By:
Paloma Kubiak

The return from a UK government bond (gilt) turned negative last week and remains low, so should investors consider corporate bonds for a steady income?

Traditionally in times of stock market volatility, government bonds are considered a safe way of preserving capital as the chances of a government not paying money back is low.

Following the landmark Brexit vote, anxious investors flocked to government bonds, pushing up prices and pushing down yields. In fact, gilt yields (interest rates) fell into negative territory last week for the first time. And although they have rebounded, they remain low.

According to Thomson Reuters Datastream, a one-year gilt currently offers an average yield of 0.22%, a three-year 0.14% and a 10-year 0.81%.

So what are the options for yield-starved investors?

Russ Mould, investment director at AJ Bell, says one possibility in the current environment is a move up the risk spectrum into the world of corporate bonds.

What are corporate bonds?

Corporate bonds are bonds (or debt) issued by a company looking to raise money.

They’re deemed to be higher risk than government bonds as companies are theoretically more likely to default than governments. To compensate for this higher risk, they tend to pay out higher rates of interest.

Corporate bonds – much like government bonds – are given a credit rating, which indicates the ability of the issuer to pay the investor.

Ratings are set by big agencies, Moody’s, Fitch and Standard & Poor’s.

AAA or Aaa down to BBB- or Baaa are known as investment grade bonds and are considered safer investments. Bonds rated BB+ (Ba1) or below are known as high yield or ‘junk’ bonds.

In theory, the higher the rating the less risky the bond (or loan), and the greater the chance the issuer pays the interest on time and ultimately repays the loan when the bond matures.

How can you access corporate bonds?

Retail investors typically access corporate bonds through corporate bond funds.

David Coombs, head of multi-asset investments at Rathbone Unit Trust Management, says retail investors should approach investing in individual corporate bonds with caution.

“Personally, I would be very concerned about retail investors accessing individual corporate bonds because there are so many factors to consider and they can be difficult to sell when the market is distressed. A diversified fund, which is backed by a manager with a strong track record in the space, might be a better option,” he says.

There are a wide range of actively-run and passively-managed funds available to UK investors.

The best performing open-ended investment companies in the GBP corporate bond category over the last five years, according to AJ Bell, are:

  • Fidelity Institutional UK Long Corporate Bond (Inc) – 4.21% dividend yield
  • JP Morgan Sterling Bond (dist) – 4.32% dividend yield
  • PIMCO UK Long-term Corporate Bond Inst (Inc) – 3.85% dividend yield
  • Schroder Institutional Long-Dated Corporate Bond – 4.28% dividend yield
  • Insight Investment UK Corp Long Maturity Bond (Inc) – 3.73% dividend yield

Another way to access the asset class is through investment trusts. There are nearly 30 investment trusts dedicated to investing in debt, although not all are pure plays on corporate debt.

Some specialise in other areas such as peer-to-peer lending and while this grouping has a limited trading history, Mould says the overall yield on the sector of 6.7% “suggests the investment companies as a group lean more toward the riskier end of the lending spectrum.”

The top performing debt-specialist investment companies over the last five years to end of June, according to AJ Bell, are:

  • Carador USD – 13.4% dividend yield
  • Duet Real Estate – 12% dividend yield
  • NB Global Floating Rate Income USD – 4.1% dividend yield

Another option is exchange traded funds (ETFs), which are designed to track or mirror the performance of baskets of corporate debt securities, and provide their total return, minus the costs of running these passive funds.

The best performing ETFs in the GBP corporate bond category over the last five years, according to AJ Bell, are:

  • iShares Core £ Corporate Bond – 2.4% dividend yield
  • iShares Core £ Corporate Bond ex Financials – 3.78% dividend yield
  • iShares Core £ Corporate Bond 0-5 year – 2.72% dividend yield

Is now a good time to look at corporate bonds?

Mould says there are three primary reasons why now might be a good time to look at corporate bonds.

The most obvious is that sovereign debt is offering less and less yield.

The second reason is that global inflation expectations continue to sink, meaning that purchasing power increases. The five-year, forward inflation expectation rate in the US now stands at just 1.44% and 1.38% in Europe.

“Any corporate bond or fund that yields above this may therefore catch the eye of those investors looking for some positive real yield in exchange for some capital risk,” says Mould.

The third reason is that besides advisers and clients, there is a new buyer in town – the European Central Bank.

Mould says that as of early June, the EU’s central bank began funnelling chunks of its €80bn a month Quantitative Easing (QE) scheme into corporate bonds for the very first time, having previously limited itself to buying just government debt.

He explains: “From a capital point of view this is good news if you already hold corporate bonds (directly or through a fund), as it does drive up prices (and therefore yields down). From the perspective of potential new buyers, it could be seen as an opportunity, or even a call to action to ‘buy now while prices last’.

However, Louise Babin, senior collectives analyst at Charles Stanley, says now is not a particularly compelling time to access the asset class.

“The additional income investors are currently receiving above (risk-free) government debt seems fair compensation for the level of company defaults we are currently seeing, however defaults are at historically low levels so should they increase investors would expect to receive a higher level of income.

“The nature of bonds is such that typically an increase in the yield (income received) of a bond held is paired with a fall in the value of that bond.  Therefore future returns for investors in corporate bonds are closely tied to the financial health of companies.”

She says that in an environment of continued low, but positive global economic growth and benign inflation, defaults should remain at low levels.

“However should fears of recession or another financial crisis become mainstream then there is plenty of scope for the expected rate of defaults to rise sharply from here and returns from corporate bonds to turn negative,” she adds.