Bubble trouble

7 October 2010 | By Chris Salih

Investing in the corporate bond sector has again hit top gear, prompting further concerns of a price bubble in the sector.

Last week, the Investment Management Association revealed that the corporate bond sector has leapt to the top of its rankings with net retail sales of £573m, its bestselling month since May 2009.

This total compares with net inflows of £259.4m in July and £130.3m in June. It is also important to note that alongside corporate bonds, the strategic bond and global bond sectors were among the top five best-selling sectors for the second month in a row.

Bonds were also the biggest-selling asset class in August with net retail sales of £1.2bn - the highest for bonds since May 2009. Equity sales stood at £479m.

The bond sector has been dubbed both a once in a lifetime and once in a decade opportunity in the past two years but now concerns centre on prospects of a bubble.

Earlier this month, PSigma UK equity income fund manager Bill Mott warned of a bond bubble that could rival the dotcom boom and bust if deflation is averted.

He says: “Under these circumstances, holders of 10-year US government bonds on 2.5 per cent nominal yields and UK government bonds on 3 per cent could suffer significant capital losses.”

PSigma fund manager Bill Mott warned of a bond bubble that could rival the dotcom boom and bust

Cazenove head of strategy and economics Richard Jeffrey says current gilt yields are artificially low and offer poor value at 10 years and only slightly better value at 20 and 30 years. He says for there to be a bond price bubble, it is necessary to consider what returns may be expected from other assets, namely equities.

He says: “We believe equities will generate a premium that will at least match that measured when comparing returns from the two asset classes over long periods.

“To provide extra insurance, particularly against near-term uncertainty, we suggest investors focus on higher-yielding defensive shares.

“This leaves one last question, what would be a fair level for longer-term gilt yields? To the extent that gilt yields are a measure of the risk-free return and to the extent that the true risk-free return is the long-run nominal growth rate of the wider economy, we would suggest a level of not less than 4 per cent and, for longer maturities, much closer to 5 per cent.”

Hargreaves Lansdown head of research Mark Dampier has rejected the concerns, saying there is no reason for bonds not to continue doing well in the short term.

He says: “I have been told by a number of bond managers that gilts at 4 per cent are ridiculously priced and we are now at 3 per cent. I do not see why we could not go to 2 per cent.

“I expect a sub-par continuation recovery that is both boring and slow. In that scenario, bonds could continue to do well, particularly corporate and high yield. I do not think bonds offer superb value on a 10-year view but I would not get out of them for the near future.”

Skerritt Consultants head of investments Andrew Merricks says there could be a bubble but not at this stage.

He says: “It all depends on whether we are entering a Japanese-style deflationary era. If we are then government bonds are not in a bubble and yields will fall further. If we are not, we are already in a bubble because if inflation snaps back, rates go up and bond yields will soar.

“The truth is you cannot say yes or no but they do look too expensive if you consider this a normal environment. I would suggest that investors stay close to the back door.”

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