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THE CASE FOR BONDS
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Bonds are effectively loans to governments or corporations at an agreed rate of interest with the return of the capital sum on an agreed date.* They encapsulate a broad spectrum of risk ranging from Government Stock, the most secure and, therefore, the lowest yielding through to investment grade corporate bonds and non-investment grade bonds (also known as ‘junk’ or high yield) which can pay extremely high levels of income yet are at real risk of default. Most bonds are rated by the major rating agencies such as Standard and Poors and Moodys. Grades range from AAA (the strongest) to D (in default).
If a bond is bought at issue and held until redemption, short of default, the investment return is known. However, bonds are traded in the market in the interim and like all investments there are times when they become overvalued and times when they become undervalued.
Due to the extraordinary market conditions we have witnessed over the last 17 months, prices of Government Bonds have become expensive due to safe haven buying but Corporate Bond prices have fallen precipitously, justifiably so in the case of the banks, but indiscriminately in the case of others which have been the victim of forced sellers at any price as financial markets deleverage on a huge scale.
The result is that Corporate Bonds now represent, in our opinion and the opinion of the majority of leading bond managers, a once in a lifetime buying opportunity. Non investment grade bonds are offering sky high yields at present and over 2-3 years will probably produce the best returns. However, they are more sensitive to the prospects of the underlying company and the time to look seriously at high yield will probably be in mid to late 2009.
Investment grade bonds, on the other hand are more sensitive to interest rates and with base rates in the UK likely to fall to as low as 1%, current yields in the region of 8-9% look irresistible and cannot be sustained. In order for such yields to be driven down to comparable rates with cash accounts prices must rise dramatically, thus triggering sizeable capital gains. Of course, such a scenario depends on the underlying issuers meeting their obligations and returning the principle. In the present economic environment it is inevitable that default rates will rise significantly but at current prices investment grade corporate bonds are implying a 5 year default rate of 55% against their long term average of just 0.7% and a worst figure of 2.4%.
Unlike dividends from shares which can be cut or withdrawn at the whim of a company’s board, coupons from fixed interest stock must be paid.
Hence in such uncertain times, investment grade bonds offer a degree of clarity, high yields, very limited downside and potentially exciting returns from what is traditionally a very pedestrian asset class.
Bonds are best accessed via unit trusts and OEICs managed by large investment managers with the experience and resources necessary to manage the risks and exploit the anomalies in what remain challenging conditions. We favour those funds whose mandates afford the manager considerable freedom to roam the entire market in search of the very best opportunities.
* With the exception of index-linked gilts and a small number of undated issues
November 2008
Please contact us if you require further information.
SHEPPARD DAVIES ASSET MANAGEMENT LTD
Agincourt House
Agincourt Square
Monmouth
NP25 3BT
Tel: 01600 711955
Fax: 01600 711956
Email: Contact us
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