Wednesday, 11th May 2016 09:31 - by David Harbage
Essentially, when interest rates eventually rise, the fixed coupon income of gilts will appear relatively less attractive and the capital values of such bonds (especially those not protected by imminent redemption) must inevitably fall, as their yields reflect a market offering higher rates.
However, by contrast with conventional gilts, the appeal of index-linked government stock may rise if inflation picks up (to exceed the Monetary Policy Committee’s targeted level of 2%) to partially offset an increase in interest rates (towards what might be viewed as a longer term level of a Bank or base rate of say 3%).
Higher paying bonds issued by companies with strong balance sheets and successful businesses (in particular generating sustainable profits) may have more appeal as, unlike gilts, the market does not appear to have overvalued these assets to the same extent. As an example a gilt due to redeem in 10 years’ time currently offers a return (expressed as a GRY yield) of 1.5%, whereas the market is pricing an HSBC bond and an Imperial Tobacco bond of very similar maturity to offer a yield of 5.5%.and 4.5% respectively. If you prefer to avoid banks or tobacco companies, then bonds from less economically sensitive utility businesses yield around 4% (choose from most of the UK’s biggest, including National Grid, Scottish Power or Thames Water). However, if a pickup in interest rates is inevitable, surely the attractions of any fixed income investment must diminish – including higher yielding bonds issued by our largest firms?
The universe of investment grade quality sterling corporate bonds before the financial crisis of 2008-09 featured a yield of 5%, based on an average duration of between 7-8 years. At that time, gilts of the same maturity offered circa 3.5%, which suggests that the risk premium (the additional yield paid to take the risk of investing beyond the equivalent conventional risk-free gilt) was 1.5%. Currently, that premium has extended to 3% - which reflects deterioration in the economic backdrop, and weaker sentiment towards financial issuers. While gilts appear expensive and yields might be expected to rise by 1%, on any move towards normal levels of economic activity (and with it inflation and interest rates), the financial health of the corporate sector is probably stronger than current market valuations imply. Accordingly, the risk premium of investment grade bonds over gilts could fall by 1% - offsetting the suggested 1% pick-up in gilt yields - and effectively underpinning the worth of corporate bonds.
For those investors who are uncomfortable with the notion of company bonds but are seeking higher risk-reward fixed income issues, they might wish to consider 10 year sterling denominated European Investment Bank paper (a bond backed by governments, including the UK) which yields 2%. As you can see, dear investor “you pays your money and takes your choice” along the risk-reward spectrum if you wish to acquire a 10 year interest rate. Last, but not least, an investor can seek to minimise issuer – and to some extent duration (by reference to how exposed one is to longer term interest rates) - risk by choosing a ‘basket’ of bonds, via a fund (a managed unit trust or an index-based exchange traded vehicle).
In summary, for long term savers or individuals looking to invest beyond (overnight, or no notice) cash, via London Stock Exchange listed and traded securities, these are some of the prime opportunities and their potential shortcomings:
Next week we will begin to take a look at assets which can provide some protection, in both capital and income terms, from high inflation. And, as ever, seeking to diversify and provide a balanced independent perspective on the financial landscape which the private investor faces.
David Harbage
26 February 2016
The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.