ERNS about the prospects for global growth haunt the managers of the nation’s wealth. Bonds have broadly provided better returns than equities, but investors should be mindful of the sting in the tail that could come with hyperinflation.
A FLIGHT TO SAFETY
The West is currently a tale of two bond markets. Phil Tyson of MF Global explains: “Bond yields have moved to record lows in recent months, as recession fears have grown globally. 10-year yields in the US have fallen to around 2 per cent, while those in Germany are now trading just under this level, with the UK at about 2.3 per cent.” He explains that a flight to safety has also contributed to the recent price action, as concerns about the situation in the Eurozone have continued to mount. It is hard to see this situation changing in the foreseeable future.
Yannick Naud, portfolio manager at Glendevon King Asset Management notes that at the beginning of the year most market commentators were writing off government bonds as low return, because of low yields, and risky, because of the chance of high inflation. Not now. “We are nine months into 2011 and a purchase of a 10 year Gilt on 1 January generated a 11.5 per cent return so far, versus losing 10.5 per cent for the FTSE 100.” Naud adds that UK government bonds are tax-free.
NOT ALL BONDS ARE EQUAL
Most people don’t deal directly in government bonds, but are exposed through their funds and pensions. Investors assume bonds to be the most stable asset class on the market – a safe store for your wealth, particularly when approaching retirement. However, Jason Witcombe of Evolve says not all bond funds are the same. He says some funds gain or lose more than 30 per cent of their value per year. As Witcombe advocates using bonds to reduce volatility within portfolios, he looks at the low risk end of the spectrum, “treating bonds as the water and equities as the whisky.”
Witcombe suggests that holders of bond funds become familiar with the average maturity and credit worthiness of their fund’s holdings, the charges that they are paying and their performances. On the latter point, he suggests that as well as looking at the cumulative performance, investors should look at the annual performance of their fund by calendar year. If they are yo-yoing up and down, there is a risk you aren’t getting what you want.
Of course, you can buy into bonds to turn a profit – hence the subclass of high-yield bond funds. Provided you are prepared to take on the added risk, these can be a profitable part of your portfolio. But as always performance isn’t guaranteed. Carl Astorri, global head of economics and asset strategy at Coutts expects high-yield bonds to experience higher volatility because of the more uncertain growth outlook, while he thinks “emerging-market bonds offer attractive yields with a good chance of currency appreciation as well.” Although Witcombe advises UK investors worried about currency swings impacting upon performance to buy a fund that hedges back to sterling.
LESSONS FROM JAPAN
Despite the risk of Greece going under, it is rare that governments go bust. Occasionally the authorities pull their socks up and stop spending more than they take in tax revenues. More often they deleverage public and private debt through inflation, as is happening now in the UK. However, even if the country survives bankruptcy, it might find itself suspended in purgatory – as Japan now is. In deflationary Japan, interest rates are on the floor, stimulus after stimulus has failed to ignite spending, equities are shunned and timid investors’ faith rests in the bonds of their insanely over-indebted government. If Japan is the model for where the rest of the West is going, bonds might trump equities. Adrian Lowcock of Bestinvest says with US Treasuries offering rates not seen since the 1950s, markets are currently “pricing in a Japanese scenario, which is deflationary.” The yield on Japanese debt is currently 1 per cent. However, the best diagnosticians of Japan’s disease – Albert Edward of Societe General and Bill Bonner, president of Agora Publishing – also foresee this story ending with hyperinflation. If their admittedly bleak scenario plays out, you certainly won’t want much of your wealth tied up in bonds. Investors will need to be nimble.