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How bonds beat equities

Conventional wisdom states that the best route to long-term capital gains comes though the stockmarket but is this still the case?

The definitive guide to asset returns in the UK, the Barclays&#39 gilt-equity study, gives the returns over annual periods for equities and gilts.

It is clear to see from these returns that, over a reasonable period of time – five years at a minimum – that equities do, for the most part, outperform gilts.

However, gilts are not the only available fixed-income asset. There are index-linked gilts, offering inflation protection but unfortunately low returns. And then there are corporate bonds.

Unfortunately, there is not a huge amount of data on the sterling corporate bond market. The first indices only go back to around 1996. This links back to the history of corporate bonds in the UK, where corporate bonds were typically issued as debentures or bonds secured on property.

The massive growth in corporate bonds as an asset class really started in the mid-1990s. In its gilt-equity study, Barclays has created its own index for corporate bonds going back to 1990. The returns for corporate bonds for this period can be compared with equities.

The result this gives is certainly enough to give the average saver pause for thought – corporate bonds have outperformed the stockmarket for seven out of 13 years and over the whole period produced a return of 10.3 per cent compared with 6.7 per cent for equities (average annual real rate of return, with income reinvested).

It could be argued that the 1990s were unprecedented in terms of returns for corporate bonds because of a number of factors. The change from a high to low-inflation world produced big capital gains on all fixed-interest investments as yields fell from 15 per cent to 5 per cent.

The corporate bond market became much more efficient and liquid, reducing the absolute yield on bonds in return for capital gains. It could also be argued that the 1990s was also a period of unprecedented growth for stockmarkets for many of the same reasons.

Thirteen years worth of data may not be enough to convince everyone that corporate bonds are a lower risk and a true asset class that can produce higher returns than equities but it makes a convincing argument for having corporate bonds as a key part of a balanced portfolio.

As a broad guide to holistic portfolio planning, the usual advice is to match the weighting of fixed-interest stock with your age.

The question then becomes one of “which fixed-income investments and what form should they take?” Index-linked bonds are a very low-risk and low-return asset which will probably have little appeal to investors in the current climate.

The great fear in investment markets has been falling prices, or deflation, rather than a return to the days of rampant inflation. Gilts have been the traditional way to invest in fixed income assets. They have many advantages, such as their almost complete safety, in terms of the government repaying its debt. They are very liquid assets, making them easily tradeable with a very small bid-offer spread. There is a wide choice of maturity dates from this year to 2036.

The alternative to gilts is corporate bonds. These offer less safety than gilts – but still a remarkably high level of security – but the benefit of yielding more than gilts. For a longer-term hold, they would be the preferred route in preference to gilts.

The form of the investment then comes into play. Direct investments make a lot of sense for gilts. They can be traded easily and cheaply. The choice is only one of yield and maturity. Corporate bonds, however, are still very much a closed world to the direct investor. This is usually done through having large single denominations on bonds to deter the man on the street from buying them.

The extra yield and investment opportunities do allow a fund manager to produce excess returns to cover the charges of a collective investment scheme. There are several ways that a collective investment scheme can give these benefits.

The first is through a diversified portfolio. This allows the risk to be spread so if a corporate bond should default or fail to repay either a coupon or principal, then the portfolio should not suffer significantly.

This is particularly true of high-yield, or non-investment-grade, bonds, where the risk of default is significantly higher than for investment-grade bonds. The portfolio approach also allows the fund manager to change the make-up of the corporate bonds, both by sector and by credit rating.

The flexibility to vary the investment between gilts and high-yield bonds around a core of corporate bonds is essential to our ability to add performance to the fund. We also vary the credit quality according to our view on market conditions. At present, we believe that BBB-rated bonds should outperform higher-rated bonds in a rising-rate environment. The success of our strategy to date can be seen in the outstanding performance of the Lincoln corporate bond fund.

There was much discussion at the end of 2003 that corporate bonds have had a fantastic run and that 2004 would see the collapse. Corporate bond spreads – the difference in yield to gilts – have narrowed but they are not at historical lows.

In the mid-1990s, certain AAA-rated bonds actually yielded less than gilts. This was very much to do with a tax benefit, but the actual amount that corporate bonds need to yield compared to gilts to cover the risk is actually very low. Moody&#39s and Standard & Poor&#39s study the default rates on corporate bonds, combined with the recovery rates on corporate bonds. When an issuer defaults, there is on average 40 per cent of the capital value recovered for the corporate bondholders by the creditors.

Analysis of this information indicates that the average corporate bond only needs to yield 0.05 per cent over gilts to pay for the risk of losing money for a AAA-rated bond, and around 0.60 per cent for BBB-rated bonds.

Compared with the 0.4 per cent that the average AAA bond is yielding or 1.4 per cent for BBB bonds over gilts, then there is clearly still mileage in corporate bonds.

The corporate bond unit trust sector is one of the most popular investment choices for retail investors and continued demand for corporate bonds from pension funds and life insurance companies is coupled with a fall in supply as companies issue less new debt, giving a supply and demand boost to the market.

Even more than a decade of history may not be enough to convince everyone about the returns available from corporate bonds but corporate bonds are here to stay as part of a balanced portfolio.


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