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Equities V Bonds

T he constant dripfeed of falling markets along with problems of endowments, pensions, splits, structural products and, of course, Equitable Life is translating into the worst business climate for retail financial services since 1988.

In my view, 2003 and beyond actually looks far worse. It is all too easy to join with many private investors and stick our heads in the sand and hope it will go away – it won&#39t. Never has it been more important to communicate with your clients with advice and hand-holding. What do we say – run for cover, keep it in cash, go for gilts/bonds, pile into equities – they&#39re as cheap as chips?

Cash has always been an important component of any overall portfolio despite the low rates currently on offer still investors have access without the fear of penalty and loss. What are the attractions of equities against bonds? How do we allocate assets between the two? This is causing us all furrowed brows at present. Of course, if we were sure of the economic climate over the next few years, the allocation would be easy but economic forecasts are notoriously unreliably. Ronald Reagan said: “Show an economist something working in practice and he&#39ll say – ah – but it would not work in theory.” Perhaps he was brighter than we thought.

Let us first look at the case for bonds. Here we are really talking about gilts and corporate bonds. But even this can be sub-divided further. Gilts come basically in five variations – short-dated gilts, medium, long, index-linked and undated. All are sensitive to variations on the economy. Short-dated gilts will be the least volatile and be reactive to short-term interest rates. Long and undated gilts will be far more volatile to changes in the inflation outlook because of their duration.

Corporate bonds will be responsive to economic growth changes because they are company debt and not guaranteed. Various highest-quality bonds such as AAA and AA are likely to survive and tend, therefore, to be more sensitive to interest rate changes.

Clearly, even if you decide bonds are best, your next choice could still mean the difference between positive and negative returns. For example, in 2002 it was the very highest quality corporate bonds and gilts that did well. Even a decision to underweight or avoid BBB corporate bonds which are still investment grade meant a significant difference in return. Why? Because the UK and world economies did not see any sharp recovery in growth. In addition, in the UK, technical factors also overhang the market, with institutions – particularly insurance companies – wanting to reduce their equity positions in favour of bonds. In the main, this was not an investment decision but one brought about by solvency regulations.

If we ignore non-investment grade, which tend to move with equity markets, bonds appear to look expensive against equities. What would you prefer to hold over the next 10 years – a bond yielding a little over 4 per cent where the income cannot grow or an equity yielding in excess of this with a potential for the income to rise and eventually to grow to the capital? With interest rates at 40-year lows, how much more is left for capital return in bonds? The answer seem obvious.

However, it comes with a big but. It presumes that the nature of this economic cycle is similar to others that we have seen over the last 100 years. Even if we go back to the 1950s, we see that the relationships of bonds and equities were different. In those days, they yielded more than gilts, in part to compensate for their greater risk. It cannot be inconceivable that this could happen again.

Each bubble is always precisely the same in nature – reality is suspended for a short while but it comes back with a vengeance.

This suggests that bonds are not necessarily expensive against a background of global overcapacity and too much corporate and consumer debt. Nor does it make them the bargain of the century, unless you believe that we will see Japanese-style deflation, in which case, all bets in the equ-ity market are off – just fill your boots in long-dated gilts, lock into what will then appear a bargain yield of 4 per cent and sit back and see a huge one-off capital gain appear. This is a mega macro call, and I am not brave enough to make it.

Bonds have prospered over the last three years or more, while equities have been a disaster, falling by over 50 per cent. Surely given the length of time and the size of the fall, equities have reached the bottom. Well, maybe, and here comes the but – in 1973/74 they fell by 73 per cent and in the great depression by 86 per cent. So previous bear markets may not have lasted so long but the falls were bigger. In addition, three years of falling markets, while helping to take the excesses out of the market, probably only put UK equities in fair value territory. Work done by ABN Amro shows that the real yield gap (the dividend yield less the index-linked yield) is historically very high, indicating a significant buy opportunity for UK equities. Indeed, the dividend yield on the All Share Index is now virtually double the returns available in index-linked gilts.

For the first time in around 40 years, UK equity income funds yield significantly more than cash deposits, and also far more than gilts. Indeed, quality funds such as the Lion Trust income fund are now yielding around 6.3 per cent -a level not far short of blended corporate bond funds. Any investor with anything other than a short-term perspective should be considering high yielding equities. On a 10-year horizon there must be money to be made. But the key question has to be how safe are the dividends? Here the news is mixed.

Dividend cover in the UK markets has fallen from a little. Consequently, companies have less in reserve. Taking the market as a whole, dividends actually fell in 2002 by about 1 per cent and it seems likely that in 2003 and 2004 we will see the same. UK plc income does not in the short term appear as safe as a bond.

However, in a recent survey we undertook we asked 12 of the best fund managers of equity income funds what they thought of the prospects of dividend growth for their own funds. Most were a little reticent but, taken on average, they expected a static to 3 per cent rise in their own dividends. With a starting point well above cash, investors would seem to have their own buffer against a cut in dividends. Besides those who have been relying on building society income over the last 10 years have seen a cut of 80 per cent in their income. Looking alongside this, equity income funds look far safer.

In conclusion, your preference for either bonds or equities will be governed by your clients&#39 attitude to risk, goals, constraints and what you feel is the likely economic outlook. An ardent deflationist would only be invested in undated gilts while someone seeing economic recovery however would still prefer equities. Remember too that Governments will do all they can to avoid deflation. In trying to reflate the economy we just might have an inflation problem being stored up in a few years time which certainly would not be good for bonds.

We are three years into a bear market, long in the tooth by past comparisons. By overweighting bonds now, are we not positioning client portfolios to where they should have been three years ago? Despite this, are bonds in bubble territory? Probably not. They remain supported by strong demand (the reverse for equities), a weak economy, low inflation and interest rates. UK rates are still high at 3.75 per cent on an international comparison. They could fall to 3 per cent this year, hardly an unsupportive environment for bonds. It seems a good case can be made for both.


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