Gilts and, by implication, investment grade credit are not like tech stocks in 1999 or Japanese equities in 1989, when valuations were genuinely ridiculous, and the efficiencies of bond pricing always ensures that if you hold the bond to redemption you know what you are going to get.
The big problem for most investors is that they don’t know what they are going to get as they are lumped in with loads of other investors in indecipherable bond funds (bond funds by their nature are unwieldy due to the mix of bonds within the strategy, the vagaries of fund flows and ongoing maturities of bonds).
What we do know for fact is that bond investors are now getting some of the lowest returns from gilts and high quality corporate bonds in history. Short-dated gilts pay basically nothing, medium gilts pay below the inflation target of the Bank of England – 1.75 per cent yield vs. 2.00 per cent inflation target – and 30-year gilts the princely sum of 2.5 per cent.
Performance of indices over 3yrs
Source: FE Analytics
These returns, particularly at the long end, do not compensate investors for political, inflation, default or interest rate risk, in our view. It has to be said that I am not rushing to get the battered Becket cheque book out and pencilling my paltry life savings out to Messrs Miliband and Balls for 30 years at 2.5 per cent.
But clearly some people are ‘happy’ to fill themselves to the gills with such investments and other oft-received questions from our clients are ‘who is’ and ‘why are they doing so’?
The ‘who’ is easy; utterly ridiculous regulatory pressures have forced banks, insurers and other institutions to keep their snouts firmly stuck in the gilt trough in the last few years on the premise that gilts are ‘safe’, despite ever-falling return potential and ever-rising medium term risks. Another factor is extreme income scarcity; the financial repression enforced upon savers through their ‘zero interest rate policies’ has led investors up the bond path regardless of valuations and yields.
We also cannot forget that all fixed interest investments are being manipulated either directly or indirectly by the aggressive bond purchase programmes pursued by the ECB and Bank of Japan. By rendering their own fixed interest markets 'return-free' (this is a statement of fact, as a very large proportion of the global government bond universe has a negative yield, i.e. you pay the respective governments to hold your cash!) they are forcing the natural buyers of their bonds into US and UK treasury bonds.
This has ensured that gilts and US treasuries have remained well supported despite the fact that the zero interest rate policies of the Bank of England and Federal Reserve are about to change and rates will be raised (our forecast is for the US Fed to go in June and the BoE in the first quarter of 2016).
For now a mixture of aggressive QE, low inflation and high geo-political tensions will likely keep a lid on bond yields across the UK yield curve, although we still envisage that government bond yields will rise through the year ahead.
However, investors would be wise not to believe that this status quo will last forever. At some point, perhaps not too far away in the future, a mixture of rising interest rates, higher inflation and reduced geopolitical fears will lead to a nasty hangover from the greatest bond party of all time.
Our view is that February's volatility in high quality fixed interest investments has been the opening salvo in what might be a grim war in global bond markets. Quite quickly the undeserved description of ‘safe’ could be dropped from high quality bond investments, particularly those that own the unattractive combinations of low yields and long duration.
In short, we think there is a hubble of nonsense written about gilts and we disagree that a bubble has built in bonds.
However, that is not to say that gilts and investment grade credit are good value from a medium-term perspective; in fact, once adjusted for fund fees and, more importantly, inflation we would argue the opposite. The simple fact is that gilts and investment grade credit are likely to toil badly in the next decade, particularly from a real-return perspective and standard bond funds could suffer high volatility, large drawdowns and ultimately return little.
The above conclusion is likely to create trouble for cautious investors and one of our major themes is that typical cautious portfolios have now become the riskiest portfolios on offer, due to the fact the government bonds and most investment grade credit instruments have been rendered utterly unattractive.
In short, they are pregnant with risk and lack any return potential, unless deflation and no growth is the norm. Combating that risk requires diversification, innovation and a recognition that driving future asset allocation decisions based upon historic asset class returns is totally unsuitable.
Tom Becket is chief investment officer at Psigma Investment Management. The views expressed above are his own and should not be taken as investment advice.