Last week MLC’s Brian Parker made the case for bonds as part of a diversified investment strategy. Here Fidelity’s Tom Stevenson warns of the dangers with this asset class.
Investment bubbles are hard to spot. Just ask Alan Greenspan. The former chairman of the US central bank famously warned in December 1996 that stock market investors were displaying “irrational exuberance”. He was right but his timing was wrong. It was fully three years before shares stopped rising.
So when people say that a bond market bubble is inflating today – and quite a few are doing just that – my initial response is not to panic. Investment trends tend to last much longer than logic suggests they should. And as the famous economist John Maynard Keynes said: “The market can remain irrational longer than you can remain solvent.”
However, several stories in the past week or so have made me less confident. First, I read that Britain’s pension funds now hold more of their assets in bonds than in shares. This has not been the case since the 1950s when the so-called “cult of the equity” began. Investors have not been this gung-ho about fixed income for 60 years.
Second, I saw that the US had experienced its biggest ever week for inflows into bond funds, a total of $US9.4 billion. This was almost matched by the $US9.0 billion that flowed out of equity funds in the same week.
Finally, I noted that the yield on German government bonds had fallen to 1.3 per cent, almost as low as it has ever been. At that level, investors are swapping a reduction in the real, inflation-adjusted value of their savings for the reassurance of knowing they will get their money back.
History repeating
Something quite unusual is going on. Either the world has changed completely and investors will be content with derisory yields in perpetuity, or they are setting themselves up for disappointment. None of us who have lived through the lost decade for shares since 2000 want to repeat the trick with our bonds.
Figures from the Investment Management Association confirm that it is not just government bonds that are popular today. They show that in 11 out of the last 12 months more money has flowed into corporate bond funds than into any other sector.
The traditional homes for ordinary savers’ cash – UK and European shares – have been the least popular sectors over the same period. In Australia, over the past three years, managed funds have seen some $14 billion in outflows from Australian equities, whereas Australian fixed interest has had net inflows of more than $2 billion over the same period.
It is not hard to see why investors are attracted to corporate bonds. In an environment of extremely low interest rates, it is almost impossible to achieve a decent income from a deposit account.
To achieve an acceptable return on their money investors have to take some more risk. And bonds issued by the biggest and safest companies certainly look much better value than those issued by most governments.
The danger signs
The question for me is whether investors are right to have favoured bonds over equities. I think they have done so for a good reason – because they think bonds are intrinsically safer than shares – but in doing so they may have under-played some important risks. There are four principal dangers:
- The first is that the state of the economy could continue to deteriorate, pushing up the rate of company failures. If this happens investors might demand a higher yield to compensate them for the risk that they might not get their money back. For the yield on a bond to rise its price must fall. Existing holders would lose some of their capital in this case.
- The second risk is that the economy could pick up faster than expected. If this were to happen, central banks could raise base rates from their current 300-year low. Again, prices would fall.
- The third danger is that investors could all fall out of love with bonds at the same time. Fund managers might struggle to find sufficient buyers in such a situation, which could destabilise the market.
- Finally, there is the hidden risk of inflation, which many experts think might be the inevitable consequence of the quantitative easing or money printing of the past few years. Inflation is the enemy of bonds.
So what should investors do? First, I think they should look into whether their desire for income and security might not be just as well met by investing in high-dividend paying shares. A balance of equity income and fixed income looks safer to me.
Second, they should make sure that any bond funds they invest in have the flexibility to move between different parts of the fixed income universe. Not all bonds are created equal and a good manager will know where the value lies and, crucially, where it does not.
Tom Stevenson is an investment director at Fidelity Worldwide Investment
