Investment models bother me. I have nothing against being given guidelines to follow, and diversifying within an investment portfolio is wise. But when certain aspects of a basic model seem dangerously flawed, I question the wisdom of slavishly following them.

The area that has me worried is corporate and Government bonds. Demand for these went through the roof earlier this decade, when changes in pension funding rules, coupled with the demise of Equitable Life, led to equities being dumped indiscriminately in favour of bonds and the certainty that these offered for future funding purposes.

Tougher times

Anyone holding bonds at this time saw their investment rise in value as well as receiving an attractive income in comparison to the miserly interest that was generally available from the building society. But times move a little faster than those experts who construct models based upon historic data, and I fear that corporate bonds are no longer the safe haven that many of their investors assume them to be.

A year ago, I aired these concerns in a newsletter. ‘There is some concern in certain circles about how low risk the supposedly low-risk assets, such as corporate bonds, actually are at the moment,’ I wrote, adding, ‘Theo Zemek, New Star’s bond market expert, makes a case for “junk” bonds actually being lower risk than Government and investment-grade corporates at present.’ So, a year on, what have we seen?

It hasn’t been a total disaster, but I wasn’t too wide of the mark either. At the beginning of May, the average UK gilt fund lost 1.1 per cent over one year, the average UK corporate bond fund lost 0.1 per cent in one year, the average money market fund gained 3.5 per cent in one year, while the average UK other bond fund (those largely holding “junk” bonds) returned 4.7 per cent over the same 12 months. Don’t forget that these figures are based upon income being reinvested over the period net of basic rate tax as well.

Looking forward

All well and good, you say, but what of the year ahead? It would appear that the normal risk profile within the bond market will remain topsy-turvy for as long as private equity activity remains strong in the market place. Why is this?

When a company is taken over, its bond rating will usually be upgraded to that of the new parent company. This is because the company doing the taking over will normally be stronger financially than the company being taken over. However, in the current climate of private equity groups targeting ever larger companies (e.g. Boots and Sainsbury’s) the debt rating will tend to fall, due to the lower rating of the private equity vehicle. Bond managers are thus finding the top end of the high-yield sector more attractive from a risk perspective than the lower end of the investment-grade market, particularly as almost any company is currently a potential takeover target.

With interest rates having risen again (and some seeing rates at six per cent by the year end), why should anyone invest in bonds with a potential downside risk when you can earn more from cash with no risk to capital? A good question. Unfortunately, the rules dictate that you cannot hold unlimited amounts of cash in ISAs and PEPs, so are there alternatives?

Happily, there are. Some corporate bond managers such as M&G and Gartmore are using derivative-based instruments within one or two of their bond funds to protect their portfolios to some extent from a downturn and produce some extra return.

Other funds, such as the CF Midas Balanced Income Fund, will pay just over five per cent income from a portfolio of various assets other than just bonds, while funds such as the Mackintosh High Income and the Schroder Income Maximiser have delivered income of five per cent and seven per cent respectively as well as producing a strong capital return for their investors.

Purists will argue that I am not comparing like with like, but this is my point. If there are alternatives out there in which you can invest in order to continue to meet the original requirements of income provision, is it not right that they are considered even though they don’t sit neatly within the box marked “bonds” as determined by the asset allocation tool?

It all comes down to regularly reviewing a portfolio to make sure it is still doing what you intended it to do. Above all, make sure that if you set up a low-risk portfolio at the outset don’t let it take you by surprise if the bond market was to take a tumble.

This article is from the June 2007 issue of What Investment.