I have recently been presenting a number of seminars on one of my favourite financial services topics – asset allocation. I will be looking here at projected returns from each of the major asset classes and sectors. Importantly, I will not resign myself to simply commenting on the appropriateness of the FSA's standard illustrations for investment returns (4, 6 and 8 per cent for non-pension
investments, with slightly higher assumptions for more tax-efficient vehicles) but will look more closely at what projected rates might be more appropriate for each asset class.
Along the way, I will be noting the sources of information from which these projected rates can be derived and, perhaps most important, discussing how confident we can be that our projections will actually come true.
The major asset classes that I will be looking at are cash, fixed interest (Government bonds and different investment grades of corporate bonds), index-linked gilts, commercial investment property funds (investing directly or through quoted property shares) and equities (considering different sectors within the UK as well as overseas equities).
Looking at the current rates of return on cash, I would suggest that the most convenient and reliable source of information is the Financial Times. Every weekday, six pages from the back of the Companies and Markets supplement, is a page headed Currencies, Bonds and Interest Rates. Money market rates always appear in the top right-hand quarter of the page.
In early December, money market rates (using interbank sterling rates) ranged from around 3.5 per cent for short-dated money
(deposits for up to a month) to about 4.5 per cent for longer-dated cash (between a month and one year). This range of rates indicates that the money market believes UK interest rates will rise, probably by around 1 per cent, over the coming year. There are also clear messages here for the attractions or otherwise of fixed-rate mortgages.
Most financial advisers, in my experience, do not recommend direct cash investments to clients, except perhaps through self-invested pensions, but the message for projected returns from cash funds should be very clear. Cash funds can be confidently predicted to produce a rate of investment return very close to 4 per cent a year for the foreseeable future. If every possible investment in this asset class is yielding somewhere between 3.5 and 4.5 per cent, even a complete moron could manage a fund to produce returns very close to 4 per cent.
It continues to astound me that providers are obliged to project forward at 4, 6 and 8 per cent even for investments in these funds which have not got the first chance of matching either of the two higher figures in the near future, especially after charges and internal fund taxation.
What is happening to the fixed-interest market? Dealing with
Government bonds first, redemption yields have risen over the last year or so from a low of around 4 per cent to current yields hugging 5 per cent a year for all redemption terms over three years. Under three years, yields start to resemble cash yields due to the
similarity of those investments.
Falling yields mean that gilt prices have fallen. Why have they fallen? First, because the Bank of England base rate has risen and is widely expected to rise further during the next 12 months (as indicated by the money-market figures, noted above). Second, and perhaps more pertinent, fixed-interest Government bonds and equities have for some years been negatively correlated, meaning that when one of the asset classes rises in value, the other tends to fall. Put simply, this is because there is only a certain amount of money available to be invested at any time and, if more of that money is directed towards equities, pushing those prices higher, less is available for Government bonds, pushing those prices lower.
Although gilt yields now look more attractive, investors from a year or so ago have lost around 10 per cent of their capital.
I mentioned above that redemption yields for all fixed-interest gilts with a redemption term over three years are around 5 per cent. This is known as a flat yield curve and indicates, I would suggest, the fact that every fund investing in gilts should be expected to produce near-term investment returns of 5 per cent before charges and fund taxation.
Why invest in a gilt fund, then? Why not simply buy one long-dated gilt from the National Savings Stock Register? For the most part, I have not got an answer. If I wanted to invest in gilts, I would not go anywhere near a collective fund under current market conditions, I would buy one from the Post Office. Heresy or what?
Moving on from gilts but staying within the fixed-interest asset class, there have been major developments within the corporate bond market over the last year and even over the last few months. Compared with gilt redemption yields of around 5 per cent,corporate bond redemption yields range from 5.05 to 10 per cent or more, depending on the grade of the bond. The lower the grade, the higher the redemption yield, of course.
High-grade bonds (AAA or AA) offer returns at the lower end of this range while higher-yielding bond funds typically suggest future returns of 8 to 9 per cent. Mid-range corporate bond funds, investing in bonds with typical credit ratings between B+ and A(often called strategic bond funds), invest in bonds with redemption yields of around 6.5 to 6.75 per cent.
Are any of these classes of corporate bond currently good value? Most investment commentators believe that high-grade corporate bonds offer little, no or even negative value over gilts. A yield premium of only 0.05 per cent indicates no real reward for the additional risk over gilts. What about lower-grade bonds? We will look at these in my next article.