Late for the party?

Retail investors

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Despite dwindling returns, private investors have been snapping up corporate bonds with an appetite that shows no signs of flagging. Caroline Allen finds out whether or not they have missed the boat

“Why are private investors so dumb?” demands one exasperated internet chat room correspondent. “They are the best contra-indicator around.” Relentlessly buying on past performance, despite disclaimers on every product, they come late to every party and soon get ejected, often much the poorer. Is their judgment really so very bad? Maybe they are badly advised, or are they simply victims of ruthless marketing campaigns?

The last five years have been a sizzling period for corporate bonds. The rally started with investment-grade bonds, which benefited as investors fled the crumbling equity markets. In 1998 the Merrill Lynch sterling non-gilts index offered a hefty 14.6% total return. Two years on that slid to 10.23%, and by 2002 it was 9.78%. Year to date, it is just 3.7%.

Yet in September the UK Investment Management Association reported that a quarter of all new money going to unit trusts and OEICs (open-ended investment companies) was destined for corporate bond funds. In the past year, these funds have accounted for 60% of new unit trust and OEIC sales. In July 2000, which would have been a good time to buy corporate bonds, just 4% of new money was interested.

Since July 2000, according to credit analysts, yields have come “screaming in”. As returns from investment-grade bonds fell, high-yield bonds took up the charge. According to the representative index, high-yield bond funds offered just 2.7% total return in 1998, a distressing minus 15.86% in 2000, minus 4.97% in 2002, but a staggering 25% year to date.

Investment trust companies have not experienced the same inflows because of their fiscal status. Although unit trusts and OEICs are taxed as companies, they are subject to a single rate of corporation tax at 20%. Investment trust companies pay the full rate of 30%. However, unit trusts and OEICs, if invested primarily in bond funds, can pay out income as interest, as opposed to dividend. This distribution is tax deductible, so in reality most bond funds do not pay corporation tax at all.

Environmentally friendly

In the last five years the macroeconomic environment has been extremely supportive of the corporate bond sector. Each year, a particular event has helped drive yields lower and total return higher. In 1998 it was the collapse of the hedge fund Long Term Capital Management. In 1999/2000 it was the end of the technology stocks bubble, followed by the September 11 attacks in 2001, and several big corporate accounting scandals in 2002. As the global economy faltered, central banks pumped liquidity into the markets, giving an extra impetus to bonds.

“Fund managers we speak to report that institutional and retail investors are beginning to question the value of fixed-income funds given historically low yield levels and the sell-off of the government bond markets over the summer,” says Gordon Wright at Standard & Poor’s. “There is a continued presence of institutional buyers because pension funds are beginning to restructure their portfolios, and they are seeking corporate bonds instead of equities, but it sounds like retail investors are questioning valuations.”

Investment managers say there is little evidence that retail investors missed the corporate bond rally, and far from playing catch-up, the shrewdest have the flexibility to move more quickly than many institutional investors. “Retail investors should never be ignored,” says Michael Dyson, a bond trader at Barclays Capital. “En masse they can make a big difference to flows and they can be difficult to read because they are responding to different interests.”

But are retail investors making the mistake of buying on the clever marketing of past performance that may or may not be repeated? “Of course, some are,” says one fund manager. “But they are hardly alone. Everyone does it, including many professionals who should know better. There is such strong psychology at work it is impossible to avoid a degree of influence from the track record.”

Although most investors deny they are driven by market timing, getting it wrong can be very costly. Some retail investors went into high-yield debt too early and experienced very poor absolute returns in 2000 and 2001. Those who have not yet bought might have left it too late after a strong rally in the past six months.

Investment management groups say they are not “pushing” corporate bond funds – they already exist as one of the many financial products that make up a comprehensive range. Fidelity Investments, which probably enjoys the greatest brand recognition among retail investors, says it would never encourage its retail clients to try to time the market by switching in and out of any asset class. “The whole point is to help them build a diversified portfolio which yields consistently over time,” says Fidelity spokesperson Nikki Bolton.

Colin Jackson of independent financial advisor Baronworth Investment Services says there is no question of IFAs foisting the latest asset class on their clients. “Each investor’s situation is unique – their requirements, income, savings and tax position. Every financial advisor has to take that into account for each client. Like other investors, retail players want diversification, but they are not generally switching from one investment to another.”

Jackson adds: “Corporate bond funds were originally launched to offer an alternative to equities to income seekers also looking for reasonable yield, and that’s what they still offer. The average age of my client is 67 and they are very risk averse. There is no confidence at the moment in the stock markets, no matter how much fund managers want to top up equities. However, people are prepared to take an element of risk with corporate bonds.”

The story is intact

Gareth Quantrill, investment director at Scottish Widows Investment Partnership (SWIP), says there is no doubt investors have become less risk averse and many are “looking for the next big thing”. But, he adds, the bond story is intact. “Spreads have tightened for corporate bonds, but improving economic growth will be supportive of issuers.”

Credit quality has been a concern for investors and advisors, but many asset managers think the worst is behind them, even for the high-yield market. Corporate debt defaults did climb in 2001 but the default rate dropped off in the last quarter of 2002. Credit rating agencies have projected far lower levels of default this year, and defaults are widely acknowledged to be a lagging indicator.

Spreads of high-yield bonds over five-year gilts have come in from 900bp a year ago to around 450bp now. Stephen Snowden, investment manager at Aegon Asset Management, says that despite much talk of a bubble bursting, investors can still enjoy reasonable yields. “Yes, corporate bond spreads have come in a lot, and yes, that is a gain that has been banked and is unlikely to be revisited soon. But this is not the type of asset class where you will wake up to a 30% loss.”

He says investors should get used to yields of 5.5% to 6% for bonds, compared with 6% to 9% for equities. “If retail investors are buying corporate bonds for modest and relatively consistent returns, that is perfect. If they are expecting a number one performer…well, maybe.” SWIP’s Quantrill agrees: “The 450 basis point spread available right now is probably fair value, but not much better. You’ll get what you see but not much more, and in a low inflation world, that is an attractive yield.”

Laurence Linklater, vice president fixed income at T Rowe Price, says the company’s more retail-orientated US operation continues to see good support for corporate bonds, even in the high-yield area. “There is definitely greater ease and comfort with this type of credit and of course there is the absolute performance, as corporate bonds have outperformed government bonds and underlying equities. But at the moment we would probably not be encouraging retail investors to extend their exposure.”

Retail investors and their financial advisors face a particular challenge to work out the precise focus of each corporate bond fund, and there is concern that over 55% of corporate bond fund sales are through tied agents, suggesting that commission, rather than investment strategy, is driving sales. IFAs dismiss such allegations, saying there is far more monitoring and due diligence required for any retail-orientated sales force than for many investment managers.

For Baronworth’s Jackson, one real issue is the lack of clarity on whether fees charged to retail investors are taken out of yield or capital. “It should be out of yield, but most clients are not aware of this. Typical fees on a standard corporate bond fund might be 1.0% to 1.25% per annum, and even more for a high-yield fund. That might not seem much when returns are running into double figures but with yields at current levels, it is increasingly important.”

He estimates that around half of UK corporate bond funds currently deduct fees from the capital investment, the other half from yield. “This is really something the regulator should look at. Clients nearing or in retirement can’t replace lost capital.”

Some investment managers are also concerned that retail investors, particularly those just coming to corporate bonds, are not sufficiently aware of the impact of rising interest rates or inflation on bond investments, despite the best efforts of everyone involved in the marketing of bonds to improve investor knowledge and expertise.

Bond traders say a lot of corporate bond performance has been down to the favourable underlying interest rate environment. The new uncertainty for the market is the long-term outlook for inflation, which has already led to a greater risk premium for index-linked bonds.

The direction of the US market, and sentiment towards it, will drive everything else. The US’s military commitment in Iraq and a presidential election year in 2004 suggest a steady supply of US Treasury bonds. But with foreign ownership of Treasuries now at an all-time high of 46%, the US Federal Reserve is very dependent on foreign buying support. If this showed signs of waning, US interest rates would have to rise. Ian Douglas, global fixed-income strategist at UBS calls it “an accident waiting to happen”.

Corporate issuance has dipped, as usual, over the summer, but it is likely to pick up to meet demand. “Only when fundamentals are critical is supply in this sector uncertain,” says Linklater at T Rowe Price. “Potential issuers will have used the recent low interest rate period to repair balance sheets and buy back debt, where they can. The story is improving: value is clearly not going to be ceded to equity investors so easily now, and there is better price action in the underlying equities.”

“Still,” he adds, “you have to ask if there is enough protection in yield spreads. Institutions have been trimming overweights as yields have narrowed. We would struggle to be wholeheartedly bullish from here.”

If equity markets are set for a strong and sustained rally, and interest rates start rising, the latest wave of retail investors buying corporate bonds will have a tough time. But that scenario is far from certain. Some analysts suggest equity markets could fall once more.

“It may feel like a bubble in the bond market because of recent trends,” says BarCap’s Dyson. “But perhaps it is just getting back to normal, and the 1980s and 1990s were the abnormal period. It has taken us a while to get used to these yields, but the correction is probably fair.”

“Private investors with direct holdings in redeemable bonds know they can get their money back at a predetermined date,” adds Dyson. “Gyrations in value before then are only an issue if the holding has to be sold.” Maybe those retail investors, settling for steady income and protected capital, are not so daft after all.

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