The price volatility of non-income-producing assets is also high as highly liquid investors with a negative cost of financing (after accounting for inflation) pursue inflation-beating returns.
So where does this leave the bond versus equity debate, and what advice should we give to investors?
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 resulting advice looks dangerous.
With the S&P 500 index, the main barometer for global equities, up 150 per cent in five years, should you put all your money in equities? History would suggest this might be a pretty dumb move.
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 the five-year bull market in equities can continue without a major market correction at some point soon.
We have to face up to the fact that with equities we simply do not know. We do not know in the short term whether it will be a positive or negative return, and we do not know in the long term what the return will be.
Thirteen years on since the FTSE 100 first passed 6,900, the index has still to pass this high water mark. How long is long term? Where is the inflation-plus-6 per cent “risk premium” return espoused by modern portfolio theory for those 1999 investors? Are we at another 1999-type point?
So if you do not want to forecast and want to offer some degree of certainty in the returns you provide your investors then you have to come back to the bond markets. Only with bonds with fixed maturity dates and fixed coupons can one predict what returns will be over a given time-frame.
We might not like all of the returns on offer when we look at bond returns, but we must realise this is now the price for certainty. The 1999 investor who bought a 15-year gilt paying 5 per cent probably did not much like the return either, when tech stocks were doubling every year and equity markets generally had doubled in the past five years. But with hindsight they now have exactly the expected 75 per cent return in 15 years, and will have had a pretty smooth ride along the way.
The equity investor will probably be amazed to be worse off than the bond investor with just their dividends to console them and a return of around 50 per cent over 15 years. That is, of course, if they held their nerve and did not sell out in one of the last two 40 per cent-plus bear markets. The ride along the way has been horrendous.
So before we recommend going ‘all in’ with equities we must look the clients firmly in the eye and let them realise we know very little about what equity returns will be and that the only route to a certain return is in bonds. How important is certainty to them? How will they feel if they are nursing big losses?
Income drawdown is an increasingly hot, in demand topic as pension savers wrestle with incredibly low annuity rates.
Many see drawdown as a high-risk strategy, only suitable for those investing in equities and living off the natural yield of the portfolio. Equity income as a total solution is both tax-inefficient and a recipe for disaster for anyone looking for higher drawdown levels.
The hurdle investment rate for beating an annuity pay-out to age 100 is currently only 4 per cent to 5 per cent. This can be achieved with a very high degree of certainty by investing entirely in bonds giving the same level of security as an annuity with all the extra flexibility of drawdown.
As drawdown investors found out in 2009/10, 30 per cent to 40 per cent equity market falls play havoc with your Government Actuary’s Department-imposed income limits. So unless you can tolerate these kind of swings in your income, equities are best kept to a limited exposure in drawdown.
And the nail in the coffin – drawdown investors pay tax twice on equity dividends. This little discussed phenomenon is worth considering for those investors with the choice as to where to own equities and where to own bonds, be it personally, in an Isa or in a drawdown account.
In drawdown investors suffer both the withholding tax on equity dividends in the fund and then go on to pay their marginal rates of income tax on their drawdowns.
So even a basic rate tax payer ends up paying 36 per cent tax on equity dividends. Bonds pay interest gross to the fund so the investor just pays tax once.
FIVE TOP TIPS
So on the basis that some of your clients would ideally like some certainty of return from some of their invested money, how do you go about getting the best from bonds in 2014?
1. Buy direct
Consider buying individual bonds, not just funds. Only when you hold a bond directly do you get the certainty of the return to maturity. If you can buy a bond paying 4 per cent, say, over seven years to maturity, this return will be unaffected by interest rate rises, and rates will need to rise an awful lot over the next seven years before this return is worse than sitting in a cash deposit.
2. Keep costs low
A 4 per cent return is above inflation and a decent chunk over cash rates, but if the total costs of your investment solution are more than 2 per cent it is going to lead to a very disappointed investor over time.
3. Sell early
Optimise returns by selling ahead of maturity. With persistently low rates (the perpetually moving time horizon of base rate rises), bonds will generate non-linear 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, then you might be better referring your client to a fund or bond expert.
4. Avoid gilt funds
Avoid gilt funds, vanilla corporate bond funds and short-dated bond funds. After fees the return on all of these, until interest rates have normalised, is likely to be low and less than inflation. They are now a very expensive way to diversify away from equities in a traditional balanced portfolio, and any kind of rate rise will wipe out returns.
5. Go for higher yield funds
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.
Key facts
* Bonds will always be less volatile than equities and are the only way to generate predictable returns.
* It is still possible to earn an inflation plus returns, net of fees in individual bonds with relatively low risk, but it requires very careful selection, active management and low costs.
* The return on lower risk bond and gilt funds are likely to be less than inflation net fees, they are an increasingly expensive hedge against equities in a traditional balanced portfolio.
James Baxter is a managing partner at Tideway Investment Partners
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