The name's bond -- erm, iShares iBOXX £ Corporate Bond
Corporate bonds were a bargain in early 2009. A combination of mass-selling for liquidity during the credit crunch, worries over company solvency and a deep fear of virtually everything except government bonds and cash under the mattress saw yields on corporate bonds spike well above their usual premium over gilts.
At its peak, the spread suggested more companies were going to go bust than during the Great Depression in the 1930s. Only at the very darkest hour of the crisis did that look possible, and it never looked likely.
Unusually, this was one time when everyone said something was a great buying opportunity and everyone was proved right. The best of the corporate bond funds have made stunning returns since the March lows.
Fees high -- ho hum
Fools who wanted to get involved in corporate bonds had little choice but to buy managed corporate bond funds -- an anathema for some of us.
Buying individual corporate bonds is usually deemed a dangerous enterprise for individuals, due to the real possibility of any particular company being unable to meet its obligations (i.e. going kaput). You're safer investing in a wide portfolio of bonds via an investment fund.
I'm an investment trust fan, but there's no denying they are riskier than funds due to the potential discount on their underlying assets when they fall from favour. Often a wide discount opens the potential for extra gains but it certainly also adds volatility.
Investment trusts also charge fees, as do the other main option -- managed bond funds.
These days most Fool readers will avoid ridiculous initial fees of 5% or so by buying through a fund supermarket. That still leaves annual fees and other expenses, however; even a low-ish total expense ratio (TER) of 1-1.5% will eat up a good portion of the returns from an asset with low potential for capital gains and a 4-5% income yield.
Of course, annual fees hardly matter in the context of the huge returns corporate bonds have seen this year. But the speedy realisation of such gains was by no means guaranteed in March, and we definitely can't expect the same from here.
A cheap corporate bond ETF with a catch
Usually you'd turn to exchange-traded funds (ETFs) for lower costs and excellent liquidity, at the cost of giving up the possibility, however unlikely, of a particular fund manager outperforming.
Unfortunately when corporate bonds were cheap at the start of 2009, the only sterling-based corporate bond ETF pitched at UK private investors was the iShares Corporate Bond Fund (LSE: SLXX).
This ETF certainly looked cheap; its dividend yield approached double digits at the height of the panic, and TER was just 0.2%.
But the out-sized yield gave a clue to the downside -- SLXX is stuffed full of bonds from financial companies, which were the hardest hit during the credit crisis.
It was one thing to believe we wouldn't see a fifth of companies go bankrupt in the downturn -- but it wasn't a stretch to imagine an unusually high number of banks would default. Nervous would-be investors avoided this fund for that reason.
Bye bye bank bonds
Six months on from the March lows, SLXX has delivered a capital gain of over 25% -- more like the returns from holding equities than you'd expect from bonds. The yield has dropped sharply to give a flat yield of 5.9%, and a yield to maturity of 5.8%.
It seems the panic over bank debt was overdone, and the ETF was a good purchase in retrospect (albeit beaten by the best bond funds).
But more pertinent for us today is that iShares seemingly learned from the shift in perception of banking bonds from super-safe to risky during the credit crisis.
It has therefore created a new corporate bond ETF, iShares iBOXX £ Corporate Bond ex-Financial (LSE: ISXF), which as its name implies, holds no allocation to bank debt, although there is 1.7% allocated to the 'Finance and Investment' sector. ISXF's largest holdings include the likes of Wal-Mart, Vodafone (LSE: VOD) and GlaxoSmithKline (LSE: GSK). It also eschews subordinated debt, which should make it less volatile than SLXX – at the expense of some income.
In contrast, SLXX currently has a 50% towards banking and financials, including riskier subordinated issues.
The yield on ISXF isn't bad; it boasts a flat yield of 5.5% and a yield to maturity of 4.95%, implying a slight capital loss over time from its portfolio in return for income.
Like SLXX, the TER is a very attractive 0.2%.
Back to normal
While the banking crisis hopefully lies behind us, this new iShares ex-financials ETF is a handy addition to the UK corporate bond landscape.
That said, now doesn't look half as good a time to invest in corporate bonds as earlier in the year. Some bond managers claim there's still life left in the corporate bond rally, but I'm doubtful, especially with nagging fears of a pick-up in inflation and/or bank rates next year.
With gilts currently very expensive and interest on saving rates still low though, income seekers or anyone wanting to reduce their portfolio's exposure to shares might want to add some corporate bonds. And at least with these iShares ETFs you can do so cost-effectively and with more flexibility than before.
More from Owain Bennallack:
