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Investment principles and risk

Investment principles and risk


All change for equities?

Steve Williams

In the latter half of 2012, an idea began to percolate in the investment markets. The market for government and corporate bonds would contract as investors shifted capital, en masse, to equities. It was an idea that found ready adherents, particularly among private investors, fund managers and equity-entrenched commentators.

But there is something wrong with the ‘Great Rotation’, although it works as a catch phrase and it follows in the tradition of the Great Depression, the Great Moderation and the Great Recession. Since mid-November last year, the FTSE 100 Index has risen in value by a huge

19%. If the Great Rotation hypothesis is correct, we should have seen significant flows of funds from bonds.

But the FTSE British Government All Stocks Index has edged higher today. The IMA sector averages for corporate, high yield and global bonds have all gained too. In fact, the harder you look for evidence of a great rotation of capital from bonds to equities, the harder it is to find anything substantial.

It has only been a few months, and we might find, in years to come, that the Great Rotation was indeed a financial phenomenon. However, bond market participants are not a uniformly eager to carry capital gains on bonds into the equity markets. There are bound to be some, but in the main, bondholders are attracted for reasons other than, and in addition to, price − such as liquidity, cash flow streams, liability matching and diversification. And don’t forget the central banks, increasingly the dominant holders of government bonds in the US, UK and Japan. Are these central banks going to sell bonds and buy equities?

Swings and roundabouts on yields

In April 2013 the Debt Management Office sold £1.6 billion of 1/8% Index-Linked Treasury 2024 at an effective real yield of -1.26% (a 0.125% interest coupon and a substantially negative real return). It was a record low yield for an index-linked gilt auction and for some commentators it is proof how distorted the bond market has become.

However, viewed against the corresponding  conventional gilt (Treasury 5% 2025), which yields a nominal 2%, the implied inflation rate of 3.25% a year over the next 11 years appears reasonable. In contrast, National Savings & Investments  (NS&I) are now offering what seems a generous RPI +0.15% on reinvestment of maturing index-linked certificates.

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