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Investment view

Sofia Skalistiri, who heads the bond team in our sister company, Gerrard Investment Funds, came up with an interesting piece of intelligence last week. Apparently, US bond mutual funds had their biggest inflow of money ever during August. This was before the events of September 11 and demonstrates how risk-averse investors had already become. It is almost surprising that the sell-off in the wake of the disaster was not of even greater proportions.

Bonds seem to be very much in the news at present. They were the investment of first choice for many as the outlook for the US economy took a turn for the worse. The case for bonds was helped in no small measure by the steady lowering of interest rates. Another half-point cut by the Federal Reserve last week brings US interest rates down to their lowest level for nearly 40 years and many are predicting that we have not yet seen the end of the rate-cutting.

While yields on sovereign debt are not much to write home about, corporate bonds offer more tempting returns. Admittedly, this has become a far more volatile market, with debt-rating agencies setting the tone. Telecoms bonds have massively underperformed other areas of the bond market while last week saw Swissair bonds collapse to around 10 per cent of their redemption value. You should not even think about the value of Marconi paper these days.

But, accepting the risks, it is still possible to obtain attractive yields on highly-rated corporate paper. No wonder we are seeing investors turn to this sector as they reinforce their defensive stance. Is this the right approach? Our bond team believes it is, pointing to steady demand from cautious investors and a growing need for pension funds to include them in their portfolios. There are arguments against as well.

Last week&#39s output from Lombard Street Research included a re-evaluation of equities compared with the gilt market. The yardstick to which it refers is the yield ratio, defined as the relationship between the yield on long-dated conventional gilts and the gross dividend yield on shares. This became rather unreliable in the late 1990s because of equity investors&#39 concentration on growth stocks and, thus, price-earnings ratios rather than dividend yield. This was compounded by a growing trend towards share buybacks as a way of returning value to shareholders. But a strong performance in government bonds and the fall in the equity market has once again brought the yield ratio into the spotlight.

According to Lombard Street Research, a drop in the yield ratio below 1.8x has usually been a reliable buy signal for UK equities. At the bottom of the recent market setback, the yield ratio fell to 1.5x. It last achieved this in the wake of the Asian crisis and problems surrounding Russian bonds and Long-Term Capital Management in the autumn of 1998. The rebound in the FTSE All Share index during the next year was close to 25 per cent. At the end of 1974, the yield ratio dipped to 1.4x. The figures then were truly remarkable. Gilt yields were over 17 per cent and the yield on ordinary shares 12 per cent. But the stockmarket more than doubled in 1975.

Of course, the yield ratio is a reflection of the change in the relationship between gilt yields and the dividends on ordinary shares. This difference is nowadays referred to as the reverse yield gap but, until equities suddenly became fashionable in the 1950s, it was actually a yield gap, with ordinary shares yielding more than gilts, as a reflection of the higher risk they carried. There seems no reason to believe we will return to those days but it serves as a reminder that basing everything on what has gone before will not always serve you well. Even so, those who are seeking a reason to buy into equities will doubtless settle on this as a justification.


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