What constitutes a “safe” investment? If you are an investor, what does “safe” look like? I was put in mind of the way in which the concept of “safe” will vary from person to person by comments from Michael Hughes at the Skandia/Gerrard IFA seminar in Essex.
In response to a question on how to construct a personal pension portfolio, he suggested that a significant proportion should be committed to index-linked bonds. The act-ual percentage, in his view, could be equivalent to the age of the person building the pension pot. In other words, a 50-year-old might put 50 per cent into these bonds.
Index-linked bonds have been around for a little while but the number and variety of them is increasing rapidly at present. Several countries now have these bonds in issue. In part, this is a consequence of the rising level of government indebtedness in the Western world. Government borrowing needs to be financed. The attraction of funding expenditure through index-linked securities is that interest costs are, initially at any rate, relatively low. The disadvantage, of course, is that they can rise over time while the fact that redemption values will be linked to the rise in the cost of living means that inflation cannot erode the value of the debt.
Before the first index-linked bonds were issued in this country, I remember taking part in a debate on whether or not we, as professional investors, would be prepared to buy them if they were available. The overall conclusion was that, if the Government was issuing them, we probably should not be buyers. This was, after all, a time when inflation had been very high – more than 20 per cent in the mid 1970s – but was falling. The attraction to us was the guaranteed bailout if high inflation persisted. The price we would pay was a low interest coupon and if the Government was prepared to guarantee redemption values that reflected the rise in the cost of living, the chances were that they did not expect this guarantee to prove unduly onerous.
Of course, low inflation means low interest rates so the yield on conventional bonds did fall to closer to the income return on index-linked. Interestingly, Michael Hughes did focus in on the varying experiences for investors during times of rising inflation and disinflation – two periods of almost equal length that commenced in about 1960. The main difference between the two was that equities produced positive returns in both scenarios while conventional bonds only prospered during disinflation. This period of disinflation may, as it happens, have come to an end this year. Not that rising inflation is about to hit us. Rather, a period of relative stability looks in prospect.
But to return to the question of what constitutes “safe”, can government-issued index-linked bonds really fall into this category? For a start, you have to look at the small print if you are buying a complex product such as this from a government. According to Baring's chief investment officer, legislation is already in prospect to amend the terms under which new index-linked bonds are issued, changing the inflation measure to HICP – the Harmonised Index of Consumer Prices. This may bring us into line with the Eurozone but, because property is excluded, lower guaranteed returns will be delivered than would have been available from the retail price index, under which existing bonds have been issued. This could, it is true, change, but it is worth bearing in mind.
“Safe”, too, is a concept that can vary over time. Building society and bank deposit accounts might have been considered “safe” but were they really in the dark days of the mid-1970s when inflation eroded their true worth far faster than the income generated could compensate? Indeed, I am forced to the conclusion that no investment may truly be considered safe for all time. Even conventional government bonds can have their coupons varied.
As for “safe as houses”, anyone who experienced the bear market in residential property during the early 1990s will understand that risks are present here also. In the end, it is spreading over a range of assets that gives you the greatest security. As to whether that is a “safe” approach, it depends on your point of view. No wonder assessing an investor's attitude to risk is considered so important these days. I only hope that investors themselves understand what is really meant by “risk” and “safe” in a fast-moving investment environment.