Watchdog sounds alarm over corporate bond funds

Investors buying funds that hold corporate bonds risk losing a significant amount of capital if interest rates rise and will find it hard to sell out if market sentiment plunges, the City watchdog has warned.

The Financial Conduct Authority issued the alert as bond funds continue to attract large sums from individual investors seeking a steady income.

Corporate bond funds invest at least 80 per cent of assets in "investment grade" companies, which have a low risk of defaulting on interest and capital repayments.

However, current and prospective investors are being urged to consider other risks if market conditions change or interest rates rise, which the Bank of England has signalled could happen in the months ahead.

Analysts at Barclays said the confluence of positive economic developments was "bad news" for bonds because it increased the likelihood of a rate rise. "Interest rate increases will put downward pressure on the prices of fixed-income securities, leading to mark-to-market losses for bond portfolios," they said.

The FCA is now warning about the effect of a rate rise on bonds, which could leave many investors nursing losses and spark a rush for the exit.

"Interest rate movements have an impact on corporate bond and fund unit prices," the watchdog said. "So, for example, as interest rates rise, bond prices fall. This is the key difference to deposit accounts, where the capital value is constant."

Nonetheless, experts cautioned investors not to panic. "The Bank of England will want interest rates to rise slowly, so there should be a gradual move away from corporate bonds to income on other assets, such as cash," said Laith Khalaf, head of corporate research at Hargreaves Lansdown.

He said investors could look to strategic bond funds as an alternative because these allowed managers flexibility to invest up to 20 per cent in equities while giving them the freedom to hold cash and gilts.

"The Invesco Perpetual Tactical Bond fund has more than 16 per cent in cash and equivalent investments, which can help managers protect the fund," he said. "If lots of investors head for the door and corporate bonds freeze up, then cash and gilts can meet redemptions."

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Although fund managers aim to ensure investors can buy or sell their fund holdings on any day, there is concern they would be unable to sell enough bonds to meet redemption requests in a tough market environment, leaving investors stranded.

"Investors won't get out if there's a market shock, which is what happened in 2008," said Brian Dennehy, managing director of FundExpert. "It's a bigger problem now, because investment banks have withdrawn from the market to a large extent and there's a lot of money in corporate bond funds.

"You may well see some corporate bond funds close to dealing temporarily, or cut prices sharply."

Corporate bond fund returns plummeted during the financial crisis, with the New Star Sterling Bond and Old Mutual Corporate Bond both falling around 30 per cent, according to Hargreaves Lansdown.

By comparison, the Marlborough High Yield Fixed Interest was down 44 per cent over 2008, although investors who bought the fund at the end of the year would now have gained 162 per cent.

"These [high yield] companies normally have to pay more in interest to borrow money from the market," said Darius McDermott, managing director of Chelsea Financial Services. "This is because the chance of them defaulting is greater. So companies with lower creditworthiness have to pay more to borrow money as there is a greater probability they will not pay back."

The FCA noted that even with higher quality corporate bond funds, "an unexpected default reduces income and the capital value of a bond holding".

Mr McDermott said the flexibility of strategic bond funds could help mitigate this risk, highlighting the Fidelity Strategic Bond and PFS Twenty Four Dynamic Bond as "elite" funds in the sector.

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