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Investment View

It is a while since I remarked on bonds as an investment. Given that interest rates look as though they may have peaked here and cannot be too far from the top in the US, now appears a good time to revisit this market. Aside from anything else, equities are still looking rocky. But, as it happens, Government bonds have performed well over recent weeks although some corporate bonds have behaved in a very different fashion.

The relationship between sovereign debt and other fixed-interest securities varies. A risk premium attaches to investment in the corporate sector which equates to the lik ely def ault rate. The riskiest commercial paper are so-called junk bonds. A decade or so ago, at the time of the Michael Milken debacle, the risk premium for these securities rose to 1,000 basis points. Moreover, interest rates were higher then. Generally speaking, the risk premium attached to these issues in the US averages around 3 per cent. In 1998, at the time of the Russian default and collapse of Long Term Capital Management, it rose to 6 per cent but soon settled back. Today it is around 750 basis points, which should sound alarm bells.

One reason for the risk premium being so high is the fact that yields on Government debt have fallen steadily. This is not a judgement by the market on what may happen to interest rates but a direct consequence of Governments running budget surpluses. In the US, long-dated debt is being retired. In this country there will be gilt-edged redemptions totalling £20bn next month. As Gordon Brown has a surplus of cash at his disposal, new stock issuance seems unlikely.

The other side of the coin is the need for companies to raise money to pay for those third-generation mobile phone licences. There is a lot of telecoms paper around at present. The credit-rating agencies have been downgrading many of these businesses because of the debt burden they are assuming. It is no wonder they are having to pay up to finance the deals that took place when the new economy looked altogether a more exciting place.

If you want value for money, you must look outside the Government bond market. Indeed, gilt-edged stocks, bought for many private investors to boost income and as a way of taking volatility out of portfolios, look expensive. Losses that might arise on redemption are not allowable for capital gains tax and the advantage of being able to reclaim tax on interest is only of benefit to non-taxpaying investors.

Corporate bonds offer better value but risk and volatility are greater. Bond funds spread the risk but the average total return on these funds over the past year has been a meagre 4 per cent. Even top-decile performers were lucky to generate 8 per cent. True, anyone investing in equities over the same period would probably be losing money but these are not earth-shattering figures. Worse, there are funds that have lost money, particularly those which set themselves high income criteria.

Anomalies arise from time to time in this market. Two years ago, the manager of my personal pension fund was able to buy a loan stock issued by a household name on a 14 per cent yield and sell it within a matter of weeks when the yield had returned to single figures. You have to be lucky to benefit from opportunities like that – and it demonstrates the risks.

The market appears to be factoring in some form of a credit crunch, which might be the result of a harder landing than expected in the US. Of itself, that is not enough to prevent a year-end rally taking place but it looks as though the recovery is being pushed further out. Investors need to hold their nerve. There may yet be an opportunity for bottom fishing in the equity market. The case for bonds is deferred again.


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