Bury bonds in tax-efficient Isas to avoid digging deep

 
Philip Salter
Follow Philip
HIDDEN among the carnage following the implosion of Lehman Brothers in 2008 lay an opportunity to profit from corporate bonds. And for those who weren’t busy stocking up on water, guns and canned food, corporate bond funds have proved an invaluable hedge against volatile and broadly weak equity returns and inflation’s creeping decimation of their wealth.

Hindsight is a wonderful thing and betting on corporate bonds didn’t come without risks – and it still doesn’t. Although Andrew Wells, chief investment officer of fixed income at Fidelity, points out that “high-quality investment grade corporate bonds can offer many of the characteristics once associated with sovereigns”, as Evolve’s Jason Witcombe cautions: “Bonds can be low risk if they are high quality and short dated but they can carry a huge amount of risk too – if countries can go bust, so can companies.” As John Anderson, fund manager of JP Morgan’s sterling corporate bond fund, notes: “The collapse of Lehmans in 2008 saw many bond investors lose money as bond prices fell sharply, even though interest rates were falling sharply (usually supportive of bond prices).” Although an exceptional year, Anderson acknowledges: “With bonds issued by Icelandic banks also defaulting, some bond funds fell as much as 30 per cent during that year – hardly the haven that bond funds are perceived as being.”

Of course, losing 30 per cent is better than losing everything. Danny Cox of Hargreaves Lansdown notes that an individual corporate bond relies on the strength of the company that issues the bond, so if this company goes bust the investor may suffer large losses. However, “with a bond fund there are typically over 100 different holdings providing more security should one company fail.”

“In the aftermath of the Lehman’s collapse in 2008” says Anderson, “the yields on most corporate bonds rose (and the prices of these bonds fell) sharply as markets feared a total collapse in the global economy.” However, he says that once these fears proved unfounded, investors saw that the yields on offer were very attractive: “For the past four years investors have sought a safer alternative to equities, while depositors have sought a higher return than those on offer from money market accounts, as interest rates look set to remain ‘lower for longer’ – much of this money has gone into the corporate bond market via Isas.”

TAKE COVER
Besides the diversification, there are tax advantages to shelter your corporate bond fund under an Isa wrapper. Witcombe says: “Whereas Isa managers can’t reclaim the 10 per cent tax credit on equity dividends, income and growth on bond funds is all tax free in an Isa.” Although these tax breaks may not make much difference over one year, he says the compounding factor of this tax efficiency can really add up in the long run. The restrictions come in the Isa allowance – £10,680 per person for the tax year 2011-12 – and of course the fees that you charge your fund managers.

The $1m question is: will corporate bonds continue to rise? Wells argues that many companies are now in a better position than their governments: “They have kept their cost bases under control; they continue to have access to bank lending, even if terms have become tighter, and they have actively managed their own refinancing needs in the past two years to protect themselves from this kind of volatility.” Anderson notes: “With interest rates set to remain at these very low levels for the foreseeable future, corporate bonds look set to remain well supported. Although he cautions that “the market is not without risk and any further crisis in the Eurozone could see the prices of bonds issued by European companies – most notably banks – fall in value.”

Finance 101 teaches that interest rates tend to have an inverse relationship with bond prices. Although rates don’t look like budging any time soon, if the expectations of deflation don’t materialise, governments might be forced at some point to push rates higher, especially if voters revolt against the continued redistribution of wealth from savers to debtors.