Uncertainty principle – investors now need to be very clear about why they are buying bonds

By Kevin Murphy.

Anyone looking for some light relief as the winter drags on would do well to avoid global economic headlines. To pick out a few concerns at random, there is the future of the euro, the potential for inflation, the pace of Chinese growth, the indebtedness of governments and consumers and the impact of austerity measures on countries’ populations. Not many laughs to be had there.

A common thread running through those issues is the market’s growing scepticism about politicians around the world and, taken together, all of this is creating an environment of great uncertainty. In turn, investors are seeking out certainty, which at present is perceived to be found in government bonds. We would agree – but only because bond investors are now certain of poor or even negative returns.

Yields on index-linked gilts of all durations, for example, have turned negative while investors in three-year gilts will lose money in real terms as long as inflation is anything above 1%. The latest figures show UK inflation fell in December – but only from 4.8% to 4.2%.

Undeniably bond investors are gaining more certainty in terms of the ‘coupon’ – the periodic interest payments holders receive until the bond matures. However, anyone who focuses too hard on coupon stability could end up missing a greater danger in valuation risk.

To put it another way, there is no such thing as an asset class that is always safe or an asset class that is always risky – your risk is largely determined by the price you pay. There is a tendency to view bonds as perennially safer than equities but buying equities at 1p in the pound is unlikely to be as risky as buying bonds at £2 in the pound.

A second potential danger for bond investors in the current environment is slipping into the mentality that they are only hiding out there until the outlook for equities becomes a little clearer – at which point they will switch out of bonds and into equities. If only it were that simple …

We have made the point before how markets can turn very quickly and are nearly impossible to predict but it bears repeating. Investors who remained invested in the FTSE All-Share between 1996 and 2011 enjoyed average returns of 6.3% a year. Missing just the best 10 days over that period would have reduced that average annual return to 2.3% while missing the best 30 days takes that figure into negative territory. Although you need to remember that past performance is not a guide to future performance and may not be repeated.

Timing the market is extremely difficult and in fact there is very little evidence to suggest anyone can do it at all. Add in our point about valuation risk – how, starting at today’s valuations, the prospects for equities on a three-year or five-year view now look better than for bonds – and people should ensure they are very clear indeed about why they are investing in the latter asset class.

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