bond dilemma

bond dilemma

September 13th, 2010

The bond market finds itself in a quandary. There appears to be little value at the ‘quality’ end of the market – gilt yields are at all-time lows with many barely beating inflation – and, instead, the value appears to lie in the higher-yielding, higher-risk corporates. However, if the economic environment does veer towards a double dip, no-one is likely to be buying higher-risk bonds. So the choice seems stark – sit in gilts and make nothing, but potentially save a loss of capital, or move to better-value areas, but be exposed to any lurch down in the markets. The risk/reward trade-off in gilts looks particularly weak, with myriad risks to the real value offered by the asset class. For starters, inflation may persist longer than people expect, in which case only inflation-linked gilts will protect real returns. Furthermore, interest rates may rise, which would again hurt the relative value of gilts and other government bonds. There may be few signs of any monetary tightening in the short term but, with interest rates at 0.5%, they can only go one way. Government bonds are now at levels last seen in 2008. Even if the global economy lurches towards another recession, it cannot be on the same scale as the problems seen in 2008 – yet this is precisely what the bond markets are suggesting. On the other side of the equation, it is true gilts may not fall if the economy weakens further – however, upside from these historically low yields looks limited. So where can investors hide? Strategic bond fund managers have generally focused their attention on the B to BBB area of the market. Of the top 10 strategic bond fund managers over three years, according to Trustnet, the average weighting in this part of the market is around 40%. Certainly, the consensus appears that credit should outperform on a relative basis. Spreads over government bonds remain high relative to history and investors are hungry for yield. Equally, the corporate picture remains relatively benign – companies have paid back debt and are improving earnings while default rates are low. However, any bond investor should exercise some caution. Even the most positive areas of the bond markets look relatively poor value compared to equities. There are now many solid, blue-chip companies paying dividends of 6% or 7%, with more potential upside than exists in the bond sector. There is also a danger companies will revert to less bond-friendly behaviour if the environment improves – for example, merger and acquisition activity and increasing debt. Expect ongoing volatility as a result. For all your investment needs please call Mark or Clare at GMP Independent Financial Advisers LLP on 02072886400  

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