Play your cards right and win in corporate bonds

The corporate bond sector is likely to be one of the biggest winners emerging from this year’s Isa season. Anaemic rates on cash savings have forced investors to look elsewhere for income and – with large cuts in dividends on the cards – equity income is still too risky for many.

A recent survey by uSwitch, an independent consumer comparison service, suggested approximately 4.3m investors planned to take money out of cash Isas. It estimated this was equivalent to roughly £9.5bn. Much of this money is likely to end up in the corporate bond sector, where investors can still find generous yields and greater potential for capital growth. Corporate bonds already saw strong inflows in December and January from both retail and institutional investors.

But the economic situation will undoubtedly take its toll. Defaults are rising and, while a high default rate is already priced in to the corporate bond market, significant risks remain.

The first main area that will influence fund manager performance over the next 12 months is the position on banks, which can make up as much as 40 per cent of the corporate bond indices. Bryn Jones, manager of the Rathbone Ethical Bond fund, says: “If the banks get things sorted out, there could be huge upside in these bonds and investors could double their money. But if there are still problems in 12-18 months’ time, particularly if subordinated debt coupons are withheld, investors could lose their income as well as their capital. As such, there are huge risks in buying banking debt.”

He believes it is dangerous to be out of banking names completely, but it is not an area where he is overweight and he is picking his names carefully. Curtis Evans, fixed income product manager at Fidelity International, also believes navigating financials will be vital to performance this year, but adds that much of the performance of the banking sector will come down to actions by the government and the Bank of England, which remain difficult to predict.

But the decision for fund managers is not just which banking bonds to hold, but also which type of debt. Mr Jones says the government has not yet made it clear how subordinated debt will be treated upon nationalisation. There is a possibility the lower tiers in the debt structure will not pay a coupon, which has seen these types of bonds marked down significantly. He says anyone reinvesting in banking-sector debt needs to take this into account.

With a potentially huge number of businesses defaulting on their debt, credit analysis will also be vital across the board this year, not just in the banking sector. John Hamilton, head of fixed interest at Jupiter Asset Management, says bond investors need to be circumspect because every downgrade by the rating agencies will lead to a higher cost of capital.