Juicy harvest

High-yield corporate bond funds have staged something of a comeback over the last few months. Bond fund managers launched a rash of these funds in late 1998 and early last year with juicy yields that attracted plenty of attention from investors. The story was soon eclipsed by rising real interest rates, a desire for all things technological and fears over a falling euro, but with the stock market now trading in a narrow range and offering little in the way of income, corporate bonds are once again finding favour with investors.

In particular, enthusiasm for continental European bond markets is turning many investors' heads. Helena Morrissey, manager of Newton's newly launched European High-Yield Bond Fund, says: 'The market is well positioned, with low inflation, low interest rates, merger and acquisition activity and an attractive spread of bonds and yields.'

To appreciate the argument, investors must understand what makes the bond market tick. Remember, bonds are loans from investors to organisations - ranging from companies to governments - which pay a rate of interest and are repayable on a specific date in the future. These loans are tradable securities.

Independent credit rating agencies such as Standard & Poor's and Moody's grade bonds according to the creditworthiness of the company or government issuing them. The top rating is AAA, while the lowest is a D. Only bonds rated AAA to BBB are deemed to be of investment grade - suitable for purchase by banks and other financial organisations.

High-yield bonds are generally ranked below BBB, which is why they are often described as junk bonds, but this does not make them poor investments. The lower the credit rating of a bond, the higher the yield must be to compensate investors. Put simply, the riskier the bond, the greater the reward. High-yield bond fund managers put together diversified portfolios of these bonds to offer investors an enticing income.

Ian Spreadbury, manager of Fidelity's Extra Income Fund, says: 'Based on our analysis, with 45 per cent of assets in high-yield bonds and the rest in investment-grade products, we can achieve a higher return than with conventional government-based or corporate bond funds. People find that surprising, but as long as you have good stock selection as well, you can beat most corporate bond products.'

The high-yield fund sector is primarily of interest to income-seeking investors. For the most part, these funds do not offer much potential for capital growth - indeed they may suffer losses - but sometimes junk bonds get upgraded to investment-grade status or above. This can result in attractive capital growth.

The ideal investment for a high-yield fund is a bond issued by a company that will pay interest on the loan on time and, after a while, achieves investment-grade status, thereby giving the investor an above-average income and capital appreciation. Morrissey explains: 'The ideal bond is one that goes up the credit spectrum - a company such as Orange that was a single B a couple of years ago and then upgraded to investment-grade status. It has now been bought by France Telecom.'

However, while some bond issuers move up the ratings range, others move downwards. Some companies will go bust and renege on their liabilities altogether. So, a fund with a diversified portfolio of bonds should generate returns high enough to more than make up for these defaults. In the US, defaults are currently running at about 5 per cent of total bond issues. But this is a strong period for the US economy. In June 1991, the default rate peaked at 11 per cent.

Typically, junk bonds pay bearers 10-15 per cent annual interest, although investors will only see around 7-10 per cent if they invest through a collective fund. Even so, this is juicy in comparison with the current Bank of England base rate of 6 per cent. And if the base rate dips, as many analysts expect, the gap to high-yield bond rates will climb higher. Colin Jackson of Baronsworth Investment Services, an Essex-based independent financial adviser (IFA), says: 'I think interest rates have peaked and that can only be a good thing for these products.'

Nevertheless, investors need to be wary of high-yield bonds. As with many investment trends, it is the US that has led the way on junk bonds - mostly thanks to the efforts in the 1980s of the infamous Michael Milken. Now a self-styled philanthropist, Milken wanted to revolutionise capital markets by making them more efficient, dynamic and democratic.

As head of bond trading at US bank Drexel Burnham Lambert, Milken had a solution to persuade institutions to buy the out-of-favour bonds to finance expansion and acquisitions. He eventually created a powerful network of junk bond traders that helped finance much of the merger mania of the 1980s, fuelling America's economic growth of the same period. By the end of the decade the US bond market had grown to $150 billion and Drexel Burnham was one of the biggest players.

Milken's own department was responsible for at least half of the firm's profits by the end of the 1980s and his salary leapt from $25,000 in 1970 to $550 million in 1987. But the dream went sour in 1988, when Milken was charged with securities fraud and Drexel Burnham had to pay the US government $650 million in fines. The bank eventually went bankrupt in 1990, while Milken was sentenced to 10 years in prison, ordered to pay $600 million in fines himself and was banned from the securities business for life.

Since the scandal, the US high-yield bond market has stagnated and analysts say the European market is now the one to watch. Morrissey explains: 'Over the past year there have been significant outflows from mutual funds in the US. That, coupled with lacklustre returns has meant people are beginning to believe the US has run out of steam. But we are a decade and a half behind the US and they are a very helpful model for the European investment community.'
She adds: 'In Europe, low interest rates are not eroding the real value of fixed-interest products and a benign macro-economic background is a favourable one for corporations to issue bonds. We are at the start of a major development in Europe.'

Moreover, large corporations that issue bonds to fund their operations are not always the best investments. 'British Telecom issued a bond in May of last year that has actually lost money,' says Morrissey. Deutsche Telekom has also been downgraded recently.

Start-up companies with little of the trading history or capital strength required to receive an investment-grade rating also issue bonds to obtain funding for development and expansion. The risks, however, are obvious. Start-ups might simply go bust or remain small and unspectacular. For example, a company called I-Axis issued non-investment grade bonds last year but has already gone bust. However, as long as smaller companies pay the promised interest and repay the capital, they can be deemed a successful investment.

'Fallen angels', former investment-grade companies that have fallen from grace, make up another important part of the non-investment grade part of the bond market. Companies with high levels of expensive debt might also turn to the bond markets to refinance on more advantageous terms, retire older bonds or consolidate their overall borrowings.

The junk bond market is also a favourite source of capital for leveraged buyouts, where a company issues high-yield bonds to buy a company from its shareholders. Once bought, the management will often rationalise, or asset strip, to pay off the debt.

Some companies need more capital than others, particularly those that need to upgrade infrastructure, such as those in the high-tech or telecoms markets. These companies often turn to the high-yield markets when they have exhausted capital reserves.

It is also worth noting that some high-yield bonds are issued by governments, particularly those in emerging markets. Although these can be more stable investments, the risks can sometimes be larger and more varied. Political risk especially is difficult to judge.

In global terms, the high-yield private placement market has fallen in size over the last year, which is partly due to the decline of the US. But the European market is still in its infancy compared with America. In both the US and Europe, high-yield bonds have mirrored the stock markets in that they have mainly been issued by telecoms and high-tech companies. This means supply and demand have fluctuated in line with the fortunes of these sectors.

Private investors can gain access to the high-yield bond markets directly, but the minimum dealing size in most bonds is out of the reach of the majority of investors. Those who do deal directly will usually consult an expert adviser.

In practice, though, most private investors use collective vehicles. Baronsworth's Jackson warns: 'If any Joe Soap walks into an office and buys a grade D bond, he is taking a chance.' Jeremy Hulbert of IFA Hulbert Financial Services adds: 'I've never tried to get direct access.

Investors would have to be quite wealthy to be exposed to bonds directly and would have to pay all the usual broker charges.' Similarly, Steven Scholes, a director of IFA Berry Birch & Noble, says: 'We won't advise clients on individual bonds, although we will steer them away from the impossibly high-yielding ones and pass them on to a stockbroker who specialises in them.'

High-yield bond funds generally fall within the UK Other Bonds sector, rather than the UK Corporate Bonds sector. Earlier this year, Autif, the unit trusts and Oeic providers' trade body, split the two from the UK General Bonds sector. It argued that investors were not aware of the risks involved with the higher-yielding funds in the original sector. By placing them in the new UK Other Bonds sector it is now clear which funds carry the greater danger.

Funds in the UK Corporate Bond sector must have at least 80 per cent of their assets in investment-grade bonds. Clearly, this means yields are not as high as with funds in the UK Other Bonds sector, but there is more security. Funds within the latter sector must have at least 20 per cent of their assets invested in non-investment grade securities. These vehicles are riskier but give greater exposure to high-yielding paper. Nigel Walker, an IFA with Shropshire-based firm Gee & Co, says: 'Broadly speaking, UK Other Bond funds yield around 8 per cent. This drops to around 6 per cent for UK Corporate Bond funds.'

There are just 26 funds in the UK Other Bonds sector compared with the 72 in the UK Corporate Bond sector. But more high-yielding funds are in the pipeline. Morrissey expects such products to be popular with investors over 50 looking to supplement their income.

Generally, investors in bond funds will pay an initial charge of 3.25-5.25 per cent and annual charges of 0.65-1.25 per cent. Some fund managers will charge these expenses to capital rather than income and, with a low capital-growth product, this can be a problem. Almost all funds offer an Isa wrapper and Pep transfers, and generally distribute income monthly or quarterly.

Baronsworth publishes a weekly survey of all corporate and higher-yielding bond funds, detailing the latest charges and other information. Investors also need to look at how managers build bond portfolios.

Morrissey explains: 'A lot of these companies are multinationals and, therefore, geography is not important. We take a four-step attack. First we take a thematic look at the markets and then our global/industrial equity specialists will analyse the situation. Then we will look at the fine print of the bond itself and particularly at the change of contract covenants, and finally we must ask if the price is right. It is very labour intensive.' Morrissey tends to hold bonds for between six and 18 months.

Fidelity Extra Income Fund, meanwhile, invests anywhere between 30 per cent and 45 per cent of its assets in high-yielding paper. Manager Ian Spreadbury says: 'It is currently at 40 per cent and this doesn't fluctuate a lot. It did get up to 44 per cent but not for long.' The high-yield element of the fund is sub-contracted to Fidelity's specialists in Boston. Spreadbury continues: 'We are very much bottom-up stock-pickers, which is quite unusual because fixed-interest managers tend to look at macro-economic questions predominantly. At the moment telecoms has to be a large part of our portfolio because there is little else around.'

Fidelity Extra Income is a European fund and its high-yield bonds are 15 per cent denominated in euro and 25 per cent in sterling paper. Spreadbury says: 'We have some euro denomination because the UK high-yield market was weak at the time we launched - as it has been in recent months.'

What the IFAs recommend

- Nigel Walker, Gee & Co
'Typically, the clients using these funds are after a regular monthly income, rather than capital growth. But you can't knock a lack of capital appreciation when you have had an income of 8 per cent over the years. One of our favourites is Aberdeen Fixed Interest, which is well established, worth around
?1 billion, the largest fund in its sector and has a very experienced manager.

Although it is in one of the racier sectors and management fees are charged to capital, we still like it. It is also one of the higher-paying funds. We generally prefer S&P-rated funds; Aberdeen is rated A.
'We also use Norwich Higher Income Plus. It is around ?70-80 million in size, is growing quite quickly and is now reasonably well known. It has no initial charge, which is a bonus.'


- Jeremy Hulbert, Hulbert Financial Services
'My favourite is Aberdeen Fixed Interest, which is huge and proven. Although past performance is, of course, never a guide to future performance, what else have we to go on? One of the newer funds that looks pretty good is Perpetual Monthly Income Plus.'


- Steven Scholes, Berry Birch & Noble
'We look for funds rated highly by S&P Fund Research. We quite like the M&G Corporate Bond Fund right now. It has a reasonable yield and has maintained its capital value. Things are looking quite good and if feelings are right about us reaching the top of the interest-rate cycle, it could be a smart idea to put some money in this sector.'


- Colin Jackson, Baronsworth Investment Services
'I like the M&G funds. The M&G Corporate Bond Fund has an attractive yield, no front-end charges and its 1.25 per cent management charge comes out of the yield rather than capital. There are funds with higher yields, but fees come out of the capital and, over five years, 1.5 per cent out of capital adds up.'