All good things come to an end....... slowly

28th February 2013

 

Low interest rates in the UK, driven by successive rounds of quantitative easing, may have helped the Government to finance its borrowings, but they have been no good for savers.  In their search for greater yield, they have turned to the fixed interest markets. With government stocks offering little more than cash deposits, corporate and high yield bond funds have successfully attracted significant amounts of new money. Yet, whilst these do offer a much higher yield than cash deposits, they also represent a much riskier investment proposition.

Much has been written about the so called "Great Rotation".   With bond yields at such historic lows the case for switching into cheaper assets has grown compelling. The merit of buying low and selling high is indisputable. However, as we have witnessed in the Eurozone, whilst bond yields can move at lightning speed, it is not in the interests of the Government for yields to rise sharply anytime soon. Indeed, in the MPC minutes released last week, three members, including the Governor, called for more quantitative easing and one for an open ended facility such has been adopted by the Federal Reserve. Further gilt purchases would obviously keep a lid on yields.

The market is now expecting the resumption of more extraordinary measures, not on the grounds of fighting deflation but to support growth and employment. The cost to date has been increasing inflation, with a weak pound pushing up prices and leading to a reduction in living standards. Economic growth has proved elusive with the private sector preferring to pay down debt rather than spend. Indeed, high and rising equity dividends are partly a response to diminishing confidence in their future prospects. We must see the headlines in the business sections shift their focus from dividends to news of mergers and acquisitions before we have proof of a genuine return of confidence in future economic growth.

Investors who buy fixed interest securities now should be looking for income and diversification rather than capital growth. The 'Great Rotation' should not be dismissed, but of greater concern is how to mitigate risk when the buying declines rather than the panic-selling begins. Some investors will look at alternative defensive assets but others, like pension funds, need to invest in bonds. For retail investors the additional risk techniques offered by strategic bond funds may offer a solution. These managers can construct well-diversified bond portfolios as well as wield the ability to hedge out interest rate risk. Bond or credit selection as well as hedging will be critical for these funds. To include currencies in the equation, there is a wide and deep universe to achieve positive returns.

After such a good run in this asset class, there may be some retail investors attracted into bond funds for further capital gains, but this is never a reason to hold a bond fund in a diversified portfolio.  There is a very real danger that this lesson is about to be learnt the hard way.