Corporate bonds are popular but the funds that invest in them are too expensive.
According to the Investment Management Association (IMA) the biggest selling unit trust sector for much of this year has been corporate bonds. Not surprising perhaps given the volatility of the equity sector and, indeed, the investment returns from bonds themselves, which have now outperformed equities over the last twenty years.
Sky high costs
However, there are two major problems with corporate bond funds given the recent declines in yields. First, there is usually an initial charge of about 4% for actively managed funds (often avoidable depending on where you buy). Second (less avoidable), there are total annual expense ratios (TERs) frequently amounting to 1.5%.
Now that's a heck of a lot when the yield on a 'conservative' fund is 7%. At current yields of 5% to 6% it's means you're losing up to 30% of your income to your (active) fund manager. Take off tax as well, assuming you're investing outside of an ISA, and you've just lost 50% of your income. And let's face it, most bond investors are after the income.
The alternative, of course, is to 'do it yourself'. And a couple of weeks ago the London Stock Exchange (LSE: LSE) announced a new development that should provide far better access to the bond and gilt markets for private investors. Before going into that, let's first take a look at the advantages and disadvantages of buying bonds individually rather than through funds.
Buying bonds direct
The great investment advantage of buying individual bonds direct is that you know the future income stream, maturity date and the price you will receive when the bond is redeemed on that date.
For example, the Segro (LSE: SGRO) 5.5%, June 2018 bond is trading at around 100p. Buying it guarantees (barring default) an annual yield of 5.5%, until 2018 when you will receive 100p (bonds are nearly always issued, and redeemed, at 100p). You also avoid the charges I mentioned earlier.
You get no such guarantee with a corporate bond fund, because it is constantly trading its bonds to improve returns (theoretically at least). You cannot predict either annual income or redemption value at a particular date.
Of course, the benefit of buying direct comes at a price, and it is that the bond fund typically holds hundreds of bonds and therefore the risk of any single bond defaulting is minimised. But that's no different to the equity investor who goes it alone, and let's get default into perspective.
Historically, the average default rate for investment grade bonds (rated BBB or above) is about 0.8% and the worst rate about 2.4%, according to Invesco Perpetual. So, to overcome that risk it would be prudent for the DIY bond investor to buy a portfolio of not less than ten bonds from different sectors and maturities. In attempting that you will encounter a discriminatory problem unheard of in the rest of Europe.
The current market favours institutions
The average small retail equity investor takes it for granted that if they fancy Scottish & Southern (LSE: SSE), Tesco (LSE: TSCO) or Tate & Lyle (LSE: TATE) they simply hit the keyboard and place the buy orders. Not so with bonds.
Recently Tate & Lyle issued £200m of new 10-year bonds with a rather tasty 300 basis points (3 percentage points) yield premium over gilts. That would make a good addition for a conservative private bond investor. Fat chance! Believe it or not if you want to buy that issue, or many others, the minimum order size is £50,000!
Now I'll admit there are quite a few corporate bonds that you can buy in lots of £1,000 but that's not the point. What equity investor would tolerate being excluded from buying the shares I've just mentioned? In addition, high dealing costs mean that bond prices are often agreed directly between buyer and seller rather than in a marketplace.
It is basically simpler, cheaper and more convenient for issuers to focus on the big investors (institutional investors and hedge funds), due to a combination of regulation, cost and inclination. And once again the private investor is excluded from large areas of a perfectly viable, liquid asset class.
A new solution
At long last we have a solution to this problem: a new retail bond market for private investors, which will enable the man in the street to buy and sell bonds and gilts over an electronic trading platform. Admitedly the London Stock Exchange is hedging its bets by stating that the initiative will cover "a select number of gilts and corporate bonds".
Under this new system minimum order sizes will reduce to a more manageable £1,000 and investors will be able to see live buy and sell prices. It's due to launch in February 2010.
But a true retail bond platform may have other advantages as well; here in the UK it is extremely rare for companies outside the FTSE 100 to issue bonds. A true, low-cost retail platform may encourage smaller companies and their brokers to raise more capital from debt rather than increasingly hard to find and expensive bank loans. And that may open new opportunities for the retail investor.
Watch this space.
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