By ROBERT HARLEY 05/04/2007
Corporate bonds have had mixed fortunes over the last twelve months.
High quality, lower yielding, corporate bonds have returned an average of just 1% (including income returns) while lower quality, higher yielding, bonds have proved more successful returning around 7%.
Why has this happened?
Corporate bonds pay a yield premium over UK Gilts to account for the risk of underlying companies defaulting on their interest payments. During 2006 the additional yield premium for higher quality bonds ended the year fairly close to where it started (albeit there was some volatility in between) so increasing default expectations were not a major factor. Returns appear to have been impacted by changes in the price of UK Gilts due to fears over inflation. Rising inflation and interest rates have led to investors demanding a higher yield for holding UK GIlts, causing the price (and capital values) of Gilts and hence higher quality bonds to fall. These falls have been significant enough to largely offset the benefit of any accrued income over the period.
The performance of lower quality corporate bonds on the other hand is much more dependent on the default expectations of the underlying companies. Actual default rates in this market during 2006 were minimal. This, along with a reasonably positive economic outlook, drove the risk premium on these bonds to historically low levels. Investors have therefore enjoyed both capital and income returns.
| "However, in February this year investors started to adopt a more cautious tone - positive for quality bonds." |
However, in February this year investors started to adopt a more cautious tone. Fears over high levels of consumer debt and a weak US housing market came to the surface. Inflationary expectations have subsequently fallen which as been positive for quality bonds, while investors have demanded a higher risk premium from lower quality bonds to compensate for increased economic certainty going forwards.
These events highlight the importance of having exposure to both higher and lower quality bonds in your portfolio. This may be achieved by either combining funds that specialise in each area or using a ‘strategic’ style fund where the manager has the freedom to invest across the bond spectrum.