At present every one in three funds bought by investors is a corporate bond fund. But some experts are warning that the asset class is looking bubbly. So should you abandon bonds? Last week, the price of UK government bonds (gilts) almost hit a new high (and therefore, yields hit a fresh low) after the Bank of England hinted that it could resume buying back gilts as part of an effort to stimulate the economy via quantitative easing. But this has also prompted some City pundits to warn that current gilt prices are unsustainable.
And if gilts were to implode, then they would drag down corporate bonds as well, warns Gary Potter of Thames River Capital on Citywire. “A lot is in the price. When people tell me bonds are the only game in town, it reminds me of what I heard in 2000 and 2001 when everyone said equities were the only game in town,” says Potter, “When a lot of investors are chasing one asset class, I would hesitate as there could well be a bubble forming.”
It’s easy to see why investors have been drawn to corporate bonds. They are seen as safer than stocks (if a company goes bust, bond holders get paid before shareholders), and offer a regular fixed income. But the yield on such bonds has fallen as the prices have risen. They are now at “rock-bottom levels”, says Kathryn Cooper in The Sunday Times.
In fact, the yield on some corporate bonds is so low that the same firm’s equities offer a better yield. For example, Vodafone’s dividend yield has been steady at 6%-7% for the past two years but its four-year bond yield has dropped to 2.7%. With equities offering a much better chance of capital growth as well as a decent income, the attractions of bonds are dwindling. Another concern with bonds is that if inflation jumps, the fixed income they offer becomes worth less. As a result, investors will sell out, hitting bond prices.
If we do see a double-dip, then bond yields could certainly drop further. However, they’ve already come so far that we’d be more inclined to look at higher-yielding, defensive equities instead. A decent bet could be the Invesco Perpetual High Income fund. Well-respected fund manager Neil Woodford has invested in companies that can “grow despite difficult economic conditions”, says Mark Dampier of Hargreaves Lansdown. He’s also chosen firms with “the strongest prospects for dividend growth”. The fund’s historic yield is 3.9%.