By ROBERT HARLEY 28/04/2006
If you own any gilt or investment grade bond funds in your portfolio, you may have noticed a fall in capital value so far this year.
The reason for this is an increase in fixed interest yields, as highlighted by the chart below. Yields have generally risen globally, largely due to investors demanding a higher yield to compensate for the threat of rising inflation. Higher inflation is bad news for fixed interest as it means the future redemption value will be worth less in real terms. The longer the duration on the gilt/bond the greater the impact will be.
High yield bonds have mostly been less affected because they usually have shorter durations, hence rising inflation is less of a threat to the redemption value. These bonds also tend to benefit from buoyant stockmarkets, as the fortunes of the companies issuing the bonds (hence their ability to repay the debt) is correlated to markets.
As a result the difference in yield between gilts, investment grade and high yield bonds (the credit margin) remains near an all-time low, i.e. investors are getting little reward (additional yield) for taking on increased risk. This is worrying as it suggests the market is underpricing risk. If there is a correction at some point and spreads widen this would likely be bad news for bonds, especially high yield. A further potential negative is that real inflation is much higher than official statistics suggest, so real yields are too low.
| "This suggests that bonds are currently poor value." |
This suggests that bonds are currently poor value, although the negatives are partially offset by soaring demand from pension funds. The introduction of accounting standard FRS17 has encouraged employers with final salary pension funds to adopt a more cautious approach, which has led to greater use of fixed interest, rather than equities, to match pension liabilities. Demand has also been boosted by investors chasing yield.
We believe a cautious approach to bonds is prudent, but it would be wrong to shun this asset class - fixed interest remains a sensible diversifier within portfolios as it provides a valuable hedge against falling stockmarkets. Some bond managers also try to benefit from short term market and currency movements, which can squeeze out additional returns.