We found this article from the Economist of 21.12.13 of interest in thinking about asset allocation for the new year. ‘The bond bears – inflation is falling but bonds are unloved’. The consensus bet for 2014 is that equities will outperform bonds as in 2013, yet with headline US inflation at just 1.2%, the (simplistic) real yield on 10 year Treasuries (US government bonds) is 1.8%, close to its long term average. In contrast American equities are trading at a cyclically adjusted p/e ratio of 25, well above the long term average.
Although we have noted before our distrust of the cyclically adjusted p/e ratio because of its distortions and we don’t think equities are that over-valued, we do think there is a strong case for a balanced approach which includes bonds. Although the above statistics refer to the US, ten year UK bond yields are 3% and UK CPI inflation at least is at 2.1 % and probably falling. So bonds (gilts, UK government bonds) may produce a real return as well.
What could go wrong?
Gilts performed badly in 2013; the total return on the Gilts All Stocks index was negative 3.9%. For longer gilts, 10-15 years, the returns were worse than the average at negative 7.8%. The expectations of a stronger economy and the fear of the Fed’s tapering of US bond purchases leading to higher interest rates outweighed any benefit from expected lower inflation (which indeed never really showed up in the implied inflation from index linked bond yields).
Clearly what could go wrong with holding bonds in 2014 is more of the same; with the global economy recovering, an end to QE in prospect and widely expected higher interest rates, there could be pressure on gilt prices. Moreover, if the Austrian school of economists is right about QE ending in tears, then a large inflationary tsunami is waiting to engulf the UK.
The advantages of holding gilts
As part of a balanced portfolio, gilts provide a relative safe haven alternative to cash where official rates at least are likely to remain low (see previous article). Gilts are also probably the only asset class which will do well in a truly deflationary environment (which, whilst perhaps increasingly unlikely, is still a realistic possibility in our view). Furthermore, the alternative safe havens are not that attractive; gold, which had a poor 2013, could be a candidate but we don’t like it because it has no yield and it is difficult objectively to say whether it is cheap or expensive. Property is an obvious alternative; yet, many UK investors already have a large property exposure in their own home and a direct holding suffers from a lack of liquidity which would detract from the ability to take advantage of potential falls in equity prices.
We also think gilts can be attractive for those approaching retirement; firstly, buying ten year gilts now means that we can lock into 3% returns. But also for those needing or intending to buy an annuity in the future, buying gilts provides an element of protection against the future level of interest rates. If interest rates are higher in the future, then that is essentially good news, since although the gilt may have lost value, the annuity will provide a bigger income; if interest rates are lower, then there should be a gain on the gilt which would in part compensate for the lower value of the annuity.
The Treasury 1.75% 22 gilt (priced at 91.53) currently has a redemption yield (ie cash flow yield plus, in this case, gain to maturity,) of 2.86%. If we buy this now and hold it for say six years, we will receive the 1.75% per year and, even if three year interest rates are 3% in six years time, then the gilt will still be worth approximately 96.4, so we will have a capital gain and the option of holding until maturity and getting 100 back. We think this is quite an attractive profile for the lower risk part of a portfolio.
Conventional gilts or index linked?
Our analysis shows that looking at conventional gilts and indexed linked of similar duration (cash flow profile) then inflation has to average more than 3.4% for the index linked to be a better investment than the conventional gilt. Whist this is of course possible, with central banks focused on a 2% inflation rate, we would favour the conventional gilt at this point.
In summary, we are not saying that gilts are our favoured investment in 2014 but we do think as part of a balanced portfolio they represent a reasonable risk reward ratio. If the consensus is right, then a majority holding of equities will see gains that will more than compensate for any losses on gilts. If it is wrong, we should still have some proportion of our portfolio making money.