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Investment
Quarterly - Q2 06:
Gilt alternatives |
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| While
gilts may be the safest choice for UK-based investment in
fixed income, other options from high-grade corporate to emerging
market debt are available to savvy investors. The question
though, says Iain Morse, is if now is the right time for exposure |
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To
the casual observer, it might seem like the time is ripe to
invest in bonds. Equities and property have both had a good
run and now seem to be faltering, so a contrarian’s
view of the market might lead to increased bond exposure.
“But the prognosis for them remains poor,” warns
Richard Batty, global strategist at Standard Life Investments.
Inflation expectations have increased, and central bank interest
rates are still rising in the UK, EU and USA. Any increase
in inflation threatens to depreciate bond returns pushing
their values down.
“The bottom line for charities is whether bonds are
at all suitable for them from a strategic asset allocation
point of view,” adds Alasdair Gill, lead of the charities
group at Mercer Investment Consulting. “We would be
reviewing whether they should look at alternative investment
options.”
The logic of this argument is not hard to follow. As rates
rise, bonds already in issue start to look costly and fall
in value. Worse still, in the UK, defined benefit pension
funds have been, and remain, forced buyers of bonds as a result
of their ever tightening and more prescriptive regulatory
framework. This has made gilts more expensive than the US
Treasuries, for example, and as a result the real coupon rate
on UK gilts and investment grade corporate bonds has been
compressed to a point where they look very expensive.
With Bank of England interest rates at 4.5%, the real yield
on gilts, assuming 0% retail price inflation, currently sits
around 2.4% for gilts maturing within 5 years, falling to
1.87% for those with a maturity of 5 to 15 years. Given that
UK equities currently yield approximately 3.7% with the prospect
of a 10% increase over the next twelve months, it is hard
to argue the case for increasing gilt exposure unless investors
also require capital security.
The consensus view is that property funds promise a total
return of 7% for the year to come, and even cash can be invested
to beat gilt yields. There are alternatives to gilts, notably
investment grade corporate bonds. HBOS, a AA rated borrower,
is paying a nominal yield of 6.38% or a real yield of 5.05%
on a bond maturing in 04/08, while AAA issuer Network Rail
is paying a real yield of 4.95% on a bond maturing in 03/09.
“Buying investment grade corporate debt does increase
yield,” concedes Gill, “but only by a limited
amount.”
Trustees tend to be conservative and have proved reluctant
to follow pension funds into more exotic areas such as high
yield and emerging debt. High yield, issued by corporates
with a sub-investment grade rating, pay higher yields than
investment grade bonds, but this reflects their greater risk
of default. “There is still plenty of cash around and
we don’t expect default rates to increase substantially,”
judges Batty, “but we are only half way through a longer-term
economic cycle.” As rates rise, high yield defaults
will increase making them look expensive. At present, the
real yield on Fiat Finance, for example, is 5.66%; a slim
reward for sub-investment grade paper.
Emerging debt, issued by the governments of countries like
Brazil or Turkey, may be better value. Defaults by emerging
economies, particularly those rich in oil, gas and minerals,
are now very unlikely. Indeed many of these countries are
running a balance of trade surpluses, in contrast to the UK
and US. The returns on emerging debt have tended to be better
than those on emerging equities, reflecting this imported
credit worthiness. But there are almost no emerging bonds
issued in Sterling; the most highly traded are denominated
either in US$ or euros. This makes direct investment risky
except for the very largest charities, but there are pooled
funds with low minimum cash investment limits which offer
cost effective exposure to the smaller investor.
“There are still arguments for investing in bonds,”
argues Gill. These relate to portfolio diversification and
the need to control risk. A case can be made for bonds within
a wider portfolio of assets. For charities that decide to
go down this route, there are two choices for investment.
Stockbrokers like Laing & Cruikshank, now part of UBS,
offer discretionary management of equity and bond portfolios.
As an alternative, pooled fund managers like Newton offer
a suite of appropriate bond funds to charity investors. The
minimum for each type of investment can be low, as little
as £50,000, but this only purchases an off-the-peg service.
Charities with larger amounts will find it easy to get a bespoke
service.
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