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Investment view

So, it is official. Investors would have made more money out of bonds over the past decade than backing equities in the UK. At least, that is the conclusion of the equity/gilt study from Barclays Capital. No wonder bond funds are in such demand.

The outperformance is not massive but the circumstances behind the outperformance is unusual and seem unlikely to be repeated. Back in the early 1990s, inflation was high, interest rates significantly above their current level and bond yields in double digits. Low and stable inflation, lower interest rates, and a demand for high-quality fixed-interest paper from pension funds, in particular, as a consequence of the minimum funding requirement, all combined to drive yields down and thus deliver impressive capital returns.

Equity markets were at first buoyant and then handed back much of the gains of the latter part of the 1990s. According to this study, the two-year underperformance of equities against gilts to the end of 2001 was a massive 35.5 per cent following the worst cumulative two-year performance for equities since 1973-74. This was sufficient to propel gilt-edged securities into a close second place behind equities. According to the survey, £100 invested at the end of 1990 in gilts would have grown to £328 by the end of 2001, assuming gross income is reinvested. The equity market would have returned £352 but corporate bonds – truly the stellar performer – would have returned £385. The extra push that corporate bonds received can be attributed to the way this market has developed over recent years. Again, this is unlikely to occur in quite the same way.

It has been the tradition to calculate these figures reinvesting gross income but the change in the tax treatment of dividends on ordinary shares must be making this less relevant. Any change to reflect that which is truly possible for a non-taxpaying fund must surely enhance the performance of bonds, both corporate and sovereign.

According to the Investment Management Association website, corporate bond funds were second only to UK all companies in attracting net inflows. The two sectors combined accounted for around two-thirds of net new money.

All this news is, of course, historic and comes at a time when markets on both sides of the Atlantic appear to be recovering their poise. Much of the news that has been out in the past week or so has been favourable. Business confidence is certainly on the up while revisions to economic data are suggesting that the recessionary effects in America were less severe than previously thought.

Why all this contrasts so vividly with corporate earning performance remains a mystery. Two reasons seem to be an inclination from business managers in the US to paint the blackest possible picture for 2001, having been handed the opportunity on a plate by recent events. The second – and more worrying – explanation rests on the fact that over-investment all around the world, most particularly in America, has led to surplus capacity which will take some time to work its way out. There is no sign that companies have regained pricing power, so any recovery in profitability could be hesitant.

Still, there has been a spring-like feel on trading floors recently. The recovery could be slow, given the bruising that many private investors have suffered. But overall a picture is building of markets that are beginning to look a little more investor-friendly. Event risk remains and stock-specific risk is now a significant feature when it comes to constructing portfolios. This should only help demand for collective investments but, if Isa sales are anything to go by, the retail market is, as usual, behind the professional investor in recovering confidence. With turmoil still present in the Middle East, some caution following the recent bounce does seem justified.


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