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Low-inflation outlook favours bonds

The general outlook for investment-grade corporate bonds still looks attractive this year. However, this is subject to two caveats.

First, the chief reason why bonds look a sound investment is the absence of any threat from inflation. Inflation is the bond market&#39s worst enemy. What a high-quality bond should offer is a reliable stream of income and the repayment of your capital when the bond matures. However, if investors begin to think the real value of future cashflows will be reduced markedly by inflation, then the price of bonds will fall.

At present, we see no danger of inflation rearing its ugly head. Economic recovery is sluggish and there is plenty of unused capacity in the economic system. This is why UK investors are showing rising enthusiasm for increasing their holdings of fixed interest versus other types of asset even though the level of nominal bond yields is now around 5 per cent, which looks very low by historical standards.

This nominal level of bond yields – the headline yield – is not really important as an indicator of value. What is important is the inflation-adjusted or real yield. A nominal yield of 5 per cent with inflation below 2 per cent – which is what we have today – should certainly be more attractive to investors than, say, a nominal yield of 13 per cent with inflation between 15 and 20 per cent, which was the case for a few bleak years during the 1970s.

But even allowing for the fact that investors should be concerning themselves with inflation-adjusted yields rather than nominal yields, the question remains as to whether the real yields available in today&#39s bond market offer good value. We have looked at the history of real yields during the 20th Century and grouped the decades into three principal types of economic condition.

During periods of extreme monetary instability (defined as inflation or deflation of more than 8 per cent annually), real yields did not behave at all as they do during more normal times. Between the beginning of World War One and about 1925, and during the 1970s and early 1980s, average real yields were negative. This meant that bond yields were lower than the rate of inflation. Investing in bonds could only help investors lose money slowly. Changes in the level of the nominal bond were simply overwhelmed by the volatility of the value of money.

During periods of more stability when there was only moderate inflation similar to the levels we have today, for example, between 1900 and 1915 and the 25 years after World War Two, real yields were typically rather lower than they are now.

When there has been modest but not extreme deflation, for example, between about 1922 and 1935, nominal yields were about where they are now but, because inflation was negative, real yields were considerably higher than they are now.

Since the mid-1980s, average real yields have gradually been falling but remain higher than they were during previous periods of low inflation by about 1.5 or 2 percentage points. The conclusion from this is that there is scope for real yields to fall further. Given the sound inflation outlook, this argues that nominal yields can fall further and bond prices rise. However, even without a further rise in bond prices, a stable level of income at more than double the current rate of inflation will be an attraction for many investors.

The decision of the Boots pension fund trustees to shift their entire portfolio into long-dated high-quality bonds has been widely discussed but it is only one example, albeit a very prominent one, of a more general asset allocation shift into bonds. This is not only because of the returns on offer but also because of recent regulatory changes and influences.

First, demographic considerations are persuading many pension and life funds to reallocate more assets to long-dated fixed interest to meet actuarial or prudential requirements. Schemes are maturing and certainty of returns is required.

Second, there are regulatory pressures, most notably the forthcoming intro-duction of the FRS17 accounting standard, which will require companies to inc-lude on their balance sheets changes in the value of the company&#39s defined-benefit employee pension fund.

These sorts of factors are encouraging pension funds to reduce the volatility of their portfolios by increasing their allocation in fixed interest by reducing equities, where pension funds have traditionally been rather overexposed.

Finally, a review of the minimum funding requirement to recommend using an AA-rated bond yield to discount pension funds&#39 future liabilities has given funds a further incentive to hold AA-rated bonds in preference to other assets. This continued institutional demand is a major prop to the bond market.

But I began by saying there were two caveats. The second is that stock selection is vital. The fact that a bond has a high credit rating is no guarantee that it is safe. In a recent extreme example, Enron bonds went straight from investment grade to default. Marconi, Railtrack and British Airways have all seen their bonds marked down hard from investment grade to high yield.

In these circumstances, it is extremely important that investors make sure that the fund managers they use have the depth and experience in thorough credit analysis to build and maintain a sound bond portfolio.


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