The bond is still my last word

The mantle of corporate bonds - every income seeker's favourite investment in recent years - has recently slipped. Earlier claims by fund managers and financial advisers that the funds offer an unbeatable combination of high income and minimum risk are now looking pretty thin, with bonds falling in value and income being slashed. So should you steer clear?

The mantle of corporate bonds - every income seeker's favourite investment in recent years - has recently slipped. Earlier claims by fund managers and financial advisers that the funds offer an unbeatable combination of high income and minimum risk are now looking pretty thin, with bonds falling in value and income being slashed. So should you steer clear?

They have been pitched as marginally riskier than bank or building society savings accounts, but with much better returns. With UK base rates stuck at 6 per cent, and some bonds promising income of up to 9 per cent, the reason for their popularity is obvious. If held within an ISA, these returns can be paid free of income tax. But many investors, mostly retired, may have underestimated the risks involved in corporate bonds. Traditionally seen as less risky than shares, that view may be changing.

Corporate bonds are IOUs issued by companies to raise money for their expansion. They pay a fixed rate of interest on a lump sum and are traded on the stock market. The risk you take is that the company may default on payments, but you can reduce this by spreading your money across a range of companies' bonds using a corporate bond fund offered by such companies as Aberdeen, HSBC, M&G and Norwich Union.

Income paid on bond funds ranges from 6 to almost 9 per cent, but contrary to many investors' views, neither the income nor your original capital is guaranteed. Both have dipped in recent months. The interest rate paid by an individual bond depends on the credit rating of the issuing company. Companies with lower credit ratings must pay higher interest to attract investors, which makes high-income corporate bonds relatively risky, because there is a greater chance they will default on the loan. "If you are getting income levels of 8 or even 9 per cent, you are going to take a risk that your capital could be eroded," says Alan Penny, director of Financial Discounts Direct.

Corporate bonds pay a fixed level of interest, which means they are more popular when interest rates are falling generally. "They have struggled lately because interest rates have gone up steadily over the past 18 months, which has made the income they pay less attractive to investors," says Mr Penny. Over the past three months, bond values have fallen by up to 10 per cent, while some bonds issued by telecoms companies have dropped by 20 per cent or more.

The auctioning of licences for third-generation mobile phones in the UK, Germany and Italy forced telecoms companies to stump up tens of billions of pounds that they don't have, and could only get their hands on by issuing bonds. New telecoms bond launches have saturated the market, and with supply outstripping demand, prices have slumped. Fears that economic slowdown could hit companies' ability to repay their loans has further damaged prices. Bond funds have fallen for other reasons.

CGU Monthly Income Plus, a popular fund with almost 170,000 investors, saw its income drop by nearly a fifth in recent weeks, from 7.8 per cent to 6.3 per cent. Former fund manager Hugh Everitt, who departed in March, invested heavily in preference shares, which pay an income like bonds. At least Norwich Union, which has taken over the fund following the recent merger with CGU, has made a gesture by cutting the annual management charge on the fund from 1.25 per cent to 1 per cent.

Mr Penny says corporate bond funds may still suit some, and names his favourites as Aberdeen Fixed Interest and ABN Amro High Income. "Most people invest in corporate bonds because they need the income. With interest rates low they have few alternatives, and if they want high income they must accept the risks to their capital," he adds.

Sue Whitbread, associate director with Chartwell Investment Management, says recent troubles afflicting corporate bonds show dangers of choosing investments on past performance.

"Eighteen months ago everybody was saying how wonderfully they had performed over recent years. Everybody rushed to buy at just the wrong time, when bonds were at their most expensive and interest rates were set to rise." Many investors were misled by the hype. "Bond funds were sold entirely on their headline yield, you never heard anything about their potential volatility. Some bought bonds simply because of the publicity, not because they actually wanted them," she says.

Bonds are only suitable for those wanting an immediate income. Those wanting growth from their investment should look elsewhere. "If you need high income immediately, corporate bond funds are still the best option. However, if you don't need high levels of income right now, but want your capital and income to grow over the next 20 or 30 years, you should invest in equity income funds instead, such as HSBC Growth and Income and Deutsche Equity Income."

Ms Whitbread says that like interest rates, corporate bond performance is cyclical. "The time to invest in them is just before interest rates start to fall. If you invest after rates have fallen, then prices will already have shot up and you will not get such a good deal."

Ironically, she argues that corporate bonds' recent woes could make the present a good time to buy. "Buying last year's loser is often better than buying last year's winner. In my opinion the economic environment will improve, interest rates will reduce over the next year and corporate bond prices will therefore rally.

"If you are in a struggling bond fund, I would strongly argue that you should hold onto it rather than sell now," she says. Although some internet savings accounts pay rates of up to 7 per cent, she says bonds have the edge if interest rates do start to fall. "Internet account savings rates, which are loss leaders and must fall anyway, will drop further if base rates fall generally, but corporate bond returns will stay steady," Ms Whitbread adds.

Anna Bowes, savings and investment manager with independent financial advisers Chase de Vere, agrees that the future looks brighter for corporate bonds. "Interest rates are potentially at their peak. If they start falling soon, then corporate bonds could look much more attractive."

Ms Bowes says you must exercise caution when viewing performance figures. "CGU Monthly Income Plus looks one of the best performers over five years, but in fact has been very poor over the past 18 months." She recommends Aberdeen Fixed Interest, and M&G Corporate Bond and Credit-Suisse Corporate Bond.

Contacts: Financial Discounts Direct: 0500 498 477. Chartwell Investment Management: 01225 446 556. Chase de Vere: 0845 609 2001