Returns from government bonds will be negligible over the next decade, with yields expected to reach 10 per cent in the next 10 years, according to Barclays Capital head of asset allocation Tim Bond in the latest Barclays Gilt & Equity study.
The 55th annual report, released last week, studies the trends of the past year and looks at where markets are headed. Bond believes that in real terms the return on UK gilts and US treasuries will be “very poor” but he does not hold out much hope for equities either, believing the next decade will see nominal annual equity returns of around 7 per cent, with dividends reinvested. He also expects that inflation will move above the more recent 2-3 per cent level, further eroding returns from equities and bonds.
He says: “Over the past 10-20 years, there has been a strong outperformance of government bonds over equities. That is over and the reverse will be true although the returns from both will not be particularly attractive, with lower than average nominal returns from equities.”
Bond calls an investment policy that favours bonds over equities a “disastrous investment policy” over the next decade.
Despite his gloomy outlook for the asset class, he does not recommend switching out of any government bonds and cash holdings just yet. He and colleague Michael Dicks of Barclays Wealth argue that over the next year, bonds might be the safest place. Dicks, who in the report looks at the possibility of further asset bubbles, suggests that over the next year, investors should be overweight cash, government bonds and underweight emerging market equities and commodities. He also says investors should take a small overweight position in investment-grade credit while underweighting high-yield bonds, emerging market sovereign credit, developed market equities and real estate. “This may seem like a very defensive portfolio to hold,” he says.
But Dicks says that while his model suggests investing in cash, allocations should be lighter than they have been and the underweight to real estate should be a smaller percentage.
Liontrust head of fixed income Simon Thorp says the outlook for credit is poor and that the news last week – the US indicates it will look to raise rates, China did raise its and there has been continued uncertainty over Greece – did not do anything to further the case for fixed interest.
Thorp says: “If investors were already having a gut feeling about taking some profit from their bond positions, this week will have only accelerated the negative flows around funds invested in investment grade and high yield.”
As such, he is a firm believer in the latest industry trend, including Liontrust’s own participation, towards more strategic bond vehicles which have the ability to short and hedge interest rate risks.
Liontrust absolute return credit launches next month but Thorp says if he was opening it right now, he would be net short, just like his hedge fund is currently positioned. “There are four or five sellers for every buyer right now, new issuance is trading less and high-yield issues are down. Take the Manchester United issue which went at 98.5 – it is now down at 91. That is a lot of short- term capital destruction.
“Long-only bond funds a year ago have done well for investors but for 2010, with inflation and interest rate risks rising, it is not good news for those types of funds.”
While Thorp does still see some attractive bottom-up, stock-specific, long-only opportunities within corporate credit, like Bond, he is negative on the outlook for the sovereign debt market. Since November 2008, he has felt that too many risks were being transferred to sovereign balance sheets and as such, within his hedge fund, he bought default protection on a number of EU countries’ debt. As for gilts, Thorp admits that while the UK has been here before, it looks vulnerable, particularly as the looming election creates uncertainty.
Despite the negative outlook for bonds, Thorp does not entirely buy into the argument that equities are the place to be at the moment. He points out that there have been many times in Japan when people felt it was time for a recovery and, yes, the market did have a few sharp rallies but overall it has not progressed far. He believes that in this environment, the income element from corporate bonds will be an attractive option.
The Barclays study examines returns in the main asset classes going back to 1899 and this year’s report highlights the impact of the “lost decade” in equity returns. The report shows that the percentage each year of real investment return from UK equities over the past 10 years equates to -1.2 per cent compared with a 2.6 per cent gain from gilts and 2.9 per cent from corporate bonds. Even cash did better than equities with a rise of 1.8 per cent. Over 20 years, gilts have still done better than UK equities, gaining 5.4 per cent a year v 4.6 per cent. Gilts have rarely outperformed equities over such a long time holding period, with the study highlighting that in only two other 10-year periods has it achieved just that – 1919-1929 and the following period 1929-39.
But the study also highlights that 2009 saw the best annual return from equities in some 20 years as they rose from the lows of the credit crunch. “Despite the impressive ending, the noughties proved to be a disappointing decade – the average annualised real returns over the past 10 years have been the worst since the stagflation of the 1970s,” the report reads.
Bond says Barclays’ research shows that the era of capital abundance is about to give way to capital scarcity and asset valuations are likely to display a downward trend in the decade ahead. Even with that in mind, he says: “Our analysis suggests that equities are still capable of generating a reasonably positive return over the next 10 years despite a tendency to de-rate.”
Not a ringing endorsement for advisers looking at asset allocation decisions but it highlights just how difficult their job is becoming.