Last week, we extended our look at the main asset classes by adding fixed-interest investments to money on deposit.
We looked at the comparative annual returns and volatility from each of these assets over the last 20 years to find, unsurprisingly, that the returns from gilts outstripped those from cash by a considerable margin – around 4.5 per cent per year – but “suffered” (arguably the wrong word, depending on the circumstances and requirements of the investor) considerably higher volatility.
I say unsurprisingly as we could quite confidently have expected that the higher the risk (or volatility) the higher the long-term rewards.
Now, in our search for an efficient frontier (a combination of asset classes within a portfolio to achieve maximum returns for a planned controlled level of risk), we need to examine the correlation of returns between the different asset classes. So, what has been the correlation between gilts and cash, and is the current situation likely to continue into the future?
For the answer, we need to look first of all at very short-dated gilts (less than one year to go to redemption) which have closely mirrored the annual returns from cash. This, again, is not surprising.
Both of these are virtually risk-free both in terms of anticipated returns (guaranteed at outset) and security of the underlying investment (guaranteed by banks or the Government).
Thus returns from these two investments may be said to have been highly correlated, and can be expected to remain so for the reasons noted. This in turn means that any hope or attempt at reducingportfolio risk by diversifying holdings between cash and short-dated gilts would prove generally fruitless – they will generally perform in a very similar way over a given period of time.
At the opposite end of the redemption term scale, for long-dated gilts – those with a remaining life of at least 15 years – we have to remind ourselves of the driving factor behind the market price, and therefore also behind the redemption yield, of these long-dated bonds.
Here, short-term interest rates are nowhere near as influential in the interplay of supply and demand as the expectation of longer-term rates.
Thus, by and large, the redemption yield on a 20-year fixed-interest gilt should indicate the market's expectation of average interest rates over the next 20 years (a simplification, I accept, but a major factor), not over the next 12 months or less.
As an example, if the market expects interest rates to rise, redemption yields on longer-term gilts will be higher than those on short-dated gilts.
So, what are the current comparative market rates?
At the time of writing, the rate of return on cash seven-day notice money is around 6 per cent and for one-year notice 5.5 per cent. The redemption yield on a gilt with less than one year to redemption is 5.4 per cent – unremarkably close to one-year cash.
The market, then, expects interest rates to remain at about 5.5 per cent for the next 12 months, but then what? The redemption yield on fixed-interest gilts with a remaining life span of around five years is only a little over 5 per cent, indicating (a little arguably, perhaps) that the market expects interest rates to fall by around half a percent over the next five years.
The redemption yield on 10-year gilts is 4.75 per cent, on 20-year gilts 4.5 per cent and on 30-year gilts 4.3 per cent – all apparently indicating market expectations of continuing long-term reductions in interest rates.
Care must be taken with these indicators, however.
First, these indicators have proved to be notoriously and frequently incorrect over the last few decades.
Second, the longer-term gilt market is considered distorted by excess demand created by the implications of MFR on pension schemes – strongly encouraging the purchase by those schemes of a greater amount of long-dated gilts than might otherwise have been the case.
Finally, it is worth noting that the redemption yield on a typical euro-zone five-year Government bond is around 4.5 per cent (against 5 per cent in the UK), on 10-year gilts euro-zone yields are 4.75 per cent (against a similar UK figure) and on 30-year gilts 5.3 per cent (against 4.3 per cent in the UK).
Thus euro-zone rates are expected to rise by around 1 per cent over the very long term against an expected fall of 1 per cent in the UK.
If the UK joins the euro currency, we not only adopt that common currency but also the common interest rates. This, in turn, means that either the existing euro-zone countries fall into line with us (unlikely) or that we must fall into line with them (much more likely).
We can expect longer-term fixed-interest gilts to remain somewhat volatile, and to remain quite lowly correlated with short-term cash rates.
Quite which way interest rates will go over the coming years depends on whether you believe our own (distorted) market (rates fall) or the European market if we are to join the euro (rates rise) – or consider both indicators to be notoriously unreliable (in which case we haven't really the first idea which way long-term rates will go.
The latter is probably the right answer because if rate movements really were this simple to predict, the movement would happen immediately.
One thing we do know, though, is that the short-term interest rate movements affecting returns on cash deposit will by no means necessarily be reflected in long-term expectations of interest rates which direct long-dated gilt values.
For the remainder of this week's article we will continue to look at fixed-interest investments but moving from those issued by the Government to, most notably, those issued by local authorities (local authority bonds), building societies (permanent interest bearing securities – Pibs) and companies (corporate bonds).
As all of these are fixed-interest investments they have in the past behaved, and will continue to behave, in much the same way as do their Government-backed counterparts. The only real difference between all these fixed-interest assets (apart from some differences in taxation treatment) is the expected comparative rates of return. Put simply, local authority bonds should produce higher returns than gilts as they are generally deemed to carry an additional risk in that they are only guaranteed by a local authority and not by the central Government.
Pibs should give higher returns still, backed only by leading building societies, and corporate bonds should be expected to yield the best returns, commensurate with the higher risk of having the redemption money guaranteed only by a company (although corporate bonds with the blue-chip companies could be expected to offer yields little better, if at all, than local authority bonds).
At the end of February, a typical six-year term Government bond offered a redemption yield of 5.05 per cent against similar-dated local authority bonds of 5.9 per cent. Pibs varied (but were higher than this) and corporate bonds typically offered between 6 per cent and 9 per cent (but with some, issued by smaller or less financially stable companies, offering considerably more).
Do not forget that when comparing one type of fixed-interest security against another it is important to assess the remaining period to redemption and the financial standing of the organisation issuing the instrument.
In summary so far, then, we have looked at money on deposit and fixed-interest investments and determined that the latter should be expected to continue to produce higher returns and higher volatility.
Shorter-dated fixed-interest bonds are highly correlated with cash, but this is much less so with longer dated bonds.
To try to identify an efficient frontier between only these two investments is a bit irrelevant, and so we will only start to further develop this aspect of this series after we have considered index-linked gilts next week.
Keith Popplewell is managing director of Professional Briefing