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A question of class

In my last few articles, I have been examining and discussing a number of issues which affect retirement planning decisions, or rather should affect them if clients are aware of the principles involved.

I finish this short series, in this article, by updating one of my long-term favourite topics which has relevance not only to pensions but also to all other forms of savings – the short- term conditions and the longer-term outlook for investment returns from the main asset classes.

I will, therefore, look at the investment market conditions of cash (only briefly, of course, as this is the simplest of all the asset classes to consider), fixed-interest investments (government bonds and corporate issues), property (a particular favourite of many portfolio planners over recent years) and equities.

First of all, cash. Money market interest rates indicate deposit rates of around 4.75 per cent over the short term (up to one month – the broad equivalent of interest rates on savings accounts) rising to around 5.25 per cent on longer-term rates (up to one year).

This is a clear indication that the investment market expects interest rates to rise by around 0.5 per cent over the coming year but this observation is no more or less clever than noting the predictions in the quality press regarding the Bank of England’s intentions in this respect.

As regards fixed-interest investments, we must first of all look towards the redemption yield on Government bonds (gilts). Typical shorter-term (under five years) redemption yields are currently running at around 4.8 per cent . Unsurprisingly, we can, as always, note that this figure is very close to the deposit rate on cash, as these two asset classes, over this term of years, are very similar (that is, short term, almost total guarantees, highly liquid, etc).

Gilt redemption yields over a typical medium term (five to 10 years) are currently running at around 4.6 per cent. Quite apart from the obvious impact this yield has on realistic projections for investment funds concentrating on this sector and term, technically this also shows that the market is expecting interest rates to rise in the short term but fall slightly thereafter.

As an aside, take this, if you wish, as some kind of an indicator for yourselves or your clients if you are considering the possible attractions of fixed-rate mortgages over various terms.

This view is further illustrated when also noting that the redemption yield on long term gilts is around 4.2 per cent. Thus, these combined redemption yields, as summarised in Box 1, indicate that the investment markets seem to expect that interest rates will fall further over the longer term but, among other caveats, always remember that such a technical analysis of almost all investment markets – whatever the asset class – are frequently distorted by the vagaries of supply and demand.

By way of quick example, one might imagine that the demand for longer-term fixed-interest gilts is heightened by interest from final-salary pension schemes. This might (but, I stress, only might) explain higher gilt prices at this end of the market, leading to lower yields, irrespective of the conventional view that interest rates are expected to fall.

Many fixed-interest investment funds, though, concentrate their attentions more on corporate issues rather than government bonds. What is the current state of play in this important sub-sector in which there has been important fluctuations over recent months and years?

As also shown in Box 1, high-grade corporate bonds yielding (medium term) only about 0.25 per cent over their equivalent gilt issue. Medium-grade bonds, by comparison might be judged to be little more attractive at only about 0.5 per cent over gilts while lower-grade (often known as sub-investment grade or, more colloquially but much less accurately as junk bonds) cannot really be judged in this context at all as their return depends almost entirely of the state of “junk” of the issue and company.

I will not repeat at any length a particular and important message for portfolio planners and investors of the importance of the summary in Box 1 except to remind ourselves that funds investing in gilts can barely expect, hope, or fear a gross return (that is, before charges) with much variance from around 4.5 per cent.

A reasonable expectation from corporate bond funds must therefore depend on the grade of bonds in which they are invested.

Thus, in theory, this might range from (again, noting, this suggestion excludes charges) but it must be remembered that the notionally higher rate expected from lower-grade bonds must be balanced against the higher investment risk that the bonds might default or (more likely) suffer further demise and attract a lower market capital value.

On then to the state of the commercial property market. The Investment Property Databank index (as much and well respected a guide to the commercial property market as the FTSE is to equities) reports that total returns – rental income and capital values – have over the last six months been 10 per cent and over the last three months have been only a little under 5 per cent.

The point of repeating these figures in any detail is surely obvious – there is still little or no slowdown in the attractions of commercial property to portfolio investors.

An important word of caution is required at this stage, though. In contrast to other recent years, the IPD index – reporting the split of returns between rental income and capital growth – indicates that by far the biggest part of recent property returns have been due to the impact of the growth in capital values. Rental income has accounted for only a little more than 5 per cent of the 20 per cent overall returns over the last year.

At the time of my last comment, in these pages, on this asset class rental yields were running at more than 7 per cent.

Box 1

Short-term gilt redemption yield 4.8%

Medium term gilt redemption yield 4.6%

Long term gilt redemption yield 4.2%

Typical high-grade corporate bondredemption yield 4.8%

Typical medium-grade corporatebond redemption yield 5.1%I continue to suggest that rental yields are a much greater indicator of the running investment value of this particular asset class than the short-term capital gains or losses. Thus, while remaining bullish about the attractions of commercial property in the short to medium term, I am personally much more cautious and I am now recommending my clients to follow my example for my own investments and take a few profits from the property part of a portfolio and redirect them elsewhere. No panic selling. No overall lack of commitment to this asset class, it remains attractive not only for expected investment returns relative to alternative asset classes but also for its low correlation in a typical portfolio.

My best guess for expected returns from commercial property funds over the next few years?

In my simple mathematical mind, I think that, with rental yields at around 5 per cent a year and inflation rates, which might very broadly be associated, over the longer term, with property values, of around 2.5 per cent, I am content with an outlook of about 7.5 per cent to 8 per cent a year.

This simplicity is, by the way supported by a number of leading property fund managers.

If we are perhaps to show slightly less enthusiasm for property investments for a while and cannot really see much value in cash or even less added value in fixed-interest funds, which asset class might look attractive at present?

In my next article, I will explain my increasing enthusiasm for equities, especially in the light of these views of the current outlook for alternative asset classes.


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