One-off capital gains, rather than income, have boosted returns from corporate bond funds. Investors should consider taking profits, writes Helen Pridham.

A year ago corporate bond funds were selling like hot cakes. It seemed the only way was up. Now the outlook for corporate bonds is less rosy, and the crisis in Greece and other parts of the eurozone has raised fears about the bank bonds in which many funds invest.

Last year the funds had a clear appeal. Their yields were very attractive compared with the low rates of interest being paid on cash deposit accounts. Tthe icing on the cake was the prospect of capital growth as the doomsday economic scenario that had sent their prices tumbling failed to materialise.

Sure enough, over the past year, ordinary sterling corporate bond funds have produced average total returns of 17 per cent, of which 14 per cent has come from capital growth.

Some funds have achieved much higher levels of capital growth. The top performer over one year, Henderson Sterling Bond, chalked up capital gains of 31 per cent, while other funds that achieved more than 20 per cent growth include Old Mutual Corporate Bond, Aegon Sterling Bond, Baillie Gifford Investment Grade Long Bond, BlackRock High Income, Ignis Corporate Bond and Skandia UK Fixed Interest Blend.

Such returns are not typical. Over the past three years the average total returns from bond funds were 10 per cent, of which capital growth was just 2 per cent. And capital growth is by no means guaranteed. Despite its impressive returns over the past year, Henderson Sterling Bond fund is still standing at a 15 per cent capital loss over three years, while the Old Mutual Corporate Bond and Ignis Corporate Bond funds, among others, are down more than 10 per cent since 2007.

Not surprisingly, alarm bells started to ring recently when the average corporate bond fund went down by 0.7 per cent in May. A close observer of bond funds, Brian Dennehy, principal of independent financial advisers Dennehy Weller & Co, which publishes a quarterly Bond Watch report, believes a turning point has been reached for the sector.

He argues: ‘The party is over for corporate bond funds. Sovereign debt problems are casting a shadow over the corporate bond market. Banks tend to be large holders of sovereign debt, and the volatility of bank bonds, which form a significant part of many corporate bond fund portfolios, caught many fund managers unawares.’

But not everyone is so pessimistic about the outlook for bank bonds. One advocate is Ian Robinson, manager of F&C Corporate Bond (see fund focus). Even Dennehy is not recommending that investors exit the sector. He suggests taking profits from funds that have risen strongly and focusing on those with a strong emphasis on capital preservation. His two suggestions for funds that fit this bill are Fidelity Moneybuilder and M&G Corporate Bond.

Focus on F&C corporate bond

F&C Corporate Bond has one of the highest exposures in its peer group to financial sector bonds. They account for 57 per cent of its portfolio, with bank bonds making up 31 per cent. Manager Ian Robinson believes this stance will pay off.

‘The main point of developments in the banking industry over the past couple of years has been to make them more conservative in how they run themselves,’ he explains.

‘It is a slow process. Banks are deleveraging themselves, but it cannot be done overnight. Our overriding view, as investors in bonds, is that they will become safer over the next two to three years, and in the meantime we are being paid a better yield to hold them than non-financial bonds.’

He does not see any excessive risk involved, but there may be volatility. ‘The days of banks falling over left, right and centre are gone. If it is perceived that they won’t survive, capital will be provided or mergers will take place. Most banks fail because of liquidity problems, but through their use of quantitative easing the Bank of England and the European Central Bank have shown that this is not an issue,’ he says.