Don’t join the rush for corporate bonds

Investors “are indulging in another desperate hunt for yield” with returns on cash and government paper close to zero, says Buttonwood in The Economist – hence the boom in corporate bonds. The yields on both US investment-grade corporate debt and US junk (high-risk) debt have hit record lows of under 3% and 7% respectively.

UK bond prices have risen strongly this year. Companies have been quick to cash in on the trend – by the end of October companies had issued $3.3trn of debt worldwide, close to the 2009 record.

But we think corporate bonds are now starting to look too pricey given the risks they face. One problem, in the short term, is the darkening global economic outlook. Gross domestic product (GDP) estimates are being revised down and, according to Standard & Poor’s, defaults are beginning to creep up.

There have been 64 corporate defaults worldwide this year, up from 3% at this stage in 2011. A shaky economy is a particular danger for the overheated junk-bond sector.

Longer-term, the danger to fixed-income investments is a potentially nasty jump in inflation as all the money central banks have printed begins to move around the economy more quickly. Inflation implies a rise in interest rates, which in turn points to lower bond prices.

And often, “when the market does turn, everyone will want to head for the exit at once”, says Buttonwood. Defensive equities, which look better value and are more resilient to inflation than bonds, remain the best bet for yield-seekers.

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