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Yield switch

For most investors, the last couple of years have been challenging so many are loathe to take risks. Risk aversion may come at a price, however, if it is predicated on false assumptions surrounding risk. The adage that government bonds are “risk-free” has been wheeled out so many times that the maxim has replaced fact.

True, a government bond, if bought at issue and held to maturity, does offer a predictable return but, in terms of the price of the bond, the path to maturity could be a very rocky one while inflation will erode the real value of the return.

Portfolios focused on government bonds have had a good two years but that does not mean the good times will continue. A rise in bond yields can exact a heavy price on near-term performance. A one percentage point rise in the yield on a 10-year gilt (current yield 3.8 per cent) with 10 years to maturity would lead to a fall in the bond’s price of 7.8 per cent.

The same is true for funds that are heavily invested in gilts. Unless the fund manager has tilted the portfolio to a low duration or employs derivatives to counter the interest rate risk, an investor in gilts could be nursing a capital loss if yields rise. Clearly, the reverse is also true and it is the trend towards lower inflation and interest rates over the last two years that has contributed to the strong perfor-mance from gilts and government bonds.

While the credit crisis has led to governments doling out vast sums of money, it has disguised a deeper problem – the huge structural budget deficits of the US and the UK. These deficits will be funded in the main by heavy government bond issuance at a time when appetite for government debt could begin to wane. Currently, quantitative easing has led to the Bank of England and the US Federal Reserve acting as major buyers of govern-ment bonds but this facility may soon end. If, as expected, the Government has to compete more aggressively to attract funding, government bond yields could rise, with negative implications for existing government bond prices.

The attractions of higher-yielding corporate bonds then become clear, with their generous spreads acting as a cushion against rising government bond yields.

Craig Heron is director of fund of funds at Henderson New Star

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