Steer Clear Of Corporate Bond Funds

By Ed Bowsher | 15 May 2008

| 1 Comments

This article was first sent to Fools as part of our 'The Good, The Bad and The Ugly' email series.

We don't often mention corporate bonds on The Fool. I suspect some Fools would say we should talk about them more.  After all, the returns can be pretty good. Consider these performance figures for the last ten years:

Real investment returns by asset class (% pa)

Source: Barclays Equity Gilt Study 2008

So since 1997, corporate bonds have delivered an inflation-adjusted return of 4.2% a year. They've beaten shares, gilts and cash over that period. Sounds good....

What's a corporate bond?

But before we go any further, let's clarify what a corporate bond actually is.

If a company wants to borrow money, it can go to a bank and get a conventional loan. Or it can issue bonds which are IOUs that can be traded by investors. Bondholders will receive a fixed amount of interest each year and will also receive a capital sum when the bond is wound up at maturity.

Corporate bonds are similar in many ways to gilts (government bonds) except that the risk is higher. The UK government is extremely unlikely to go bust whereas an individual company is more risky. That risk varies from company to company. Marks & Spencer will almost certainly still be solvent in ten years' time; a small technology company is more likely to fold. 

If a company goes bust, its corporate bonds become worthless.

How can you invest in corporate bonds?

Some brokers allow you to buy and sell them just like shares.

But the more popular approach is to invest in corporate bond funds. Fund managers pick what they consider to be the best corporate bonds and the funds should, in theory, deliver a decent, low-risk return.  And some funds do achieve that -- the Invesco Perpetual Corporate Bond Fund, for example, has delivered an excellent return of 87% over the last ten years, according to Citywire. (6.46% a year.)

That said, the Invesco fund is the top-performing corporate bond fund over that period!

I'm not buying.....

However, I'm not tempted to invest in corporate bonds. Here's why:

•           Yes, corporate bonds have had a good run over the last ten years. But this has been a period of low inflation which is when you'd expect bonds to do well. But it looks like we're entering a period of higher inflation due, in part, to shortages of oil and food. Higher inflation may mean that corporate bonds won't do so well.
  
•          In fact, a weaker trend may already have started. Corporate bonds had a rotten 2007, falling 5.9%.
  
•        I'm pretty gloomy about the outlook for the economy. A weaker economy will mean that more companies will go bankrupt , increasing the risk of default on corporate bonds.

And I'm even more reluctant to invest in a corporate bond fund.

•      Corporate bonds are supposed to be a low risk investment, but investing in a fund adds an extra layer of risk because you can't be sure that the fund manager will do a good job. And you no longer have the certainty of knowing exactly what your return will be, should you hold a bond until maturity.
  
•       You also have to pay charges for a fund. The Invesco Corporate Bond Fund has an initial charge of 5% and there's a 1% annual management charge.  (Admittedly, if you bought through a fund supermarket, you could reduce the charges.)

I prefer to invest my spare cash in savings accounts or shares.  Right now there are several instant access savings accounts paying a chunky 6.5% in interest, so why take any extra risk when the first £35,000 in UK savings accounts is guaranteed by the Financial Services Compensation Scheme. Check out our Savings Centre to see a range of great savings accounts.

Any money I put in a savings account is money I might need in the short-term. I'm also saving for my retirement, and I believe that shares are the best option for that kind of long-term investment.

Sure, corporate bonds have beaten shares over the last 10 years, but I suspect that's an unusual performance which probably won't be repeated over the next 10 years for the reasons outlined above.

And anyway, my investment horizon is for 20 years or longer when the chances of shares performing best are higher still.

If you want to invest for the long-term, the Index Tracker is the obvious, cheap, Foolish product. If the FTSE 100 goes up by 50%, a tracker should go up by roughly the same amount. Nice and simple.

If your horizons are shorter, then just go for a table-topping savings account. That's even simpler!

Get an excellent savings account at The Motley Fool's Savings Centre!