Corporate Bonds – The new growth area??

Corporate bonds are the latest flavour-of–the–month asset class for investors who are uncomfortable with the current volatility in equity markets and who are seeking regular income. Billions of pounds have poured into this asset class, making it the favourite sector in five of the first six months of 2012. The most popular funds have attracted more than £1 billion between them this year

However, there are concerns that the rush into these funds could result in problems similar to those caused by the flight to property funds prior to 2007, which ended with doors being slammed first of all to new investors but later, and more devastatingly, to those wanting to withdraw funds.

In July, the Financial Services Authority (FSA) wrote to investment houses asking how they would be able to cope with large-scale withdrawals. The regulator is concerned about the size to which some funds have grown at a time when the availability of new corporate bonds is contracting. Firms have been asked to “stress test” their funds and provide details of how they would deal with large scale redemptions

To ensure that withdrawals can be covered some funds, such as the successful £6.3 billion M & G Corporate bond, are limiting in-flows of new money although managers have confirmed that the fund will remain open for business.

At Chamberlain we feel that there are a few crucial factors to consider:

  • It is an undeniable fact that no fund could cope with a demand for instant encashment from all of its investors. The underlying assets held by Corporate Bond funds are fixed term commitments. Although they are tradable throughout their lifespans, if the secondary demand evaporates the fund has no option but to sit on the bonds and impose a moratorium on redemptions
  • Many take the view that large scale withdrawals are unlikely because the investor would be faced with the problem of finding a suitable alternative asset class. At present cash provides minimal returns, equities put capital at greater risk than bonds and are not guaranteed to provide a better return and property offers similar growth prospects to bonds with, perhaps, an even greater illiquidity risk.
  • Although the foregoing seems logical it denies the irrationality, or at least the short-sightedness, of market sentiment. Those same investors who have been piling into corporate bonds because this is where they have suddenly perceived a “value” opportunity are exactly the same as the ones who will take flight when rumours of difficulties begin to surface. It is quite likely that they will be the same people that lost significant amounts in the property fund boom and bust.

It is important to stress that the corporate bond sector should not be considered for short-term investment and it is highly unlikely that it would be appropriate for any investor to commit an entire portfolio to this asset class. The model Chamberlain balanced portfolio involves a commitment of only 7.5% of the fund to corporate bonds along with 5% to gilts, 10% to strategically managed bond funds and 2.5% to global bonds. An investor with this type of spread and also diversification across equity, property and cash assets does not need to dive in and out of markets in the hope of making a short term killing.