Bonds VS Equities

JAMES BAXTER

MANAGING PARTNER TIDEWAY

INVESTMENT PARTNERS

The impact of easy monetary policy in the post crisis recovery is now obvious to see. With base interest rates in the developed world economies at below 1% for 7 years and the time horizon for rate rises perpetually 18 months off, everything looks expensive.

• Income generating assets have been pushed to very high valuations, the higher the certainty of the income the higher the price: gilts, corporate bonds, London property, high yield equities all at or fast approaching generationally high relative valuations.

• The price volatility of non-income producing assets is also high as highly liquid investors with negative cost of financing (after accounting for inflation) pursue inflation beating returns.

Where does this Leave the Bond vs Equity Debate?

The case against bonds is well versed. With interest rates forecast to rise bonds will fall and should therefore be avoided. Similarly the case for equities as a protection against inflation is the general view.

If inflation is coming buy equities not bonds. The principles in both these statements are correct but the resultant strategy looks dangerous. With the S&P 500 index, the main barometer for global equities, up 150% in five years, put all your money in equities?

History would suggest this might be a pretty dumb move.

The Price of Certainty

It remains extremely difficult to forecast if and when inflation will start to rise, when interest rates might rise, what will happen to corporate profits, investor risk appetite and whether this 5 year bull market in equities can continue without a major market correction at some point soon.

So before going ‘all in’ with equities we must admit we know very little as to what equity returns will be and that the only route to a certain return is in bonds.

How important is certainty to you? How will you feel if you are nursing big losses

Getting the Best From Bonds

Here are my top 5 tips:

• Consider buying individual bonds not just funds. Only when you hold a bond directly do you get the certainty of the return to maturity.

• Keep costs low. This means using a good broker with low fixed fees and good execution in the bond market.

• Optimise returns by selling ahead of maturity.

With persisting low rates bonds will generate nonlinear returns. Paying investors disproportionately high returns ahead of the yield to maturity in the early years and less in the last few years. If this is news to you, probably have not thought about bond investing and might be better referring your client to a fund or bond expert.

• Avoid gilt funds, vanilla corporate bond funds and short dated bond funds. After fees the likely return on all of these, from here until interest rates have normalised, is likely to be low and less than inflation. Use funds that can access the higher yield market, the new issue market where rates will track up if interest rates rise and that can hedge against rate rises.

James Baxter is a Managing Partner at Tideway Investment Partners who as well as being specialist ‘at retirement’ pensions advisers run the award winning Tideway UCITS – Global Navigator absolute return bond fund