Bonds v Equities – Away Win or Score Draw?

During an unprecedented four week holiday in Lanzarote, enjoying its unique volcanic landscape, tapas bars and restaurants, I largely forgot about work. I guess the plan worked. It was somewhat surreal therefore to return to the world of stockmarkets and investing. I had to remind myself of what asset allocation and an ISA are. Did I really give advice on these in a previous life? However less than a week after my return I was back in the mood having negotiated a ton of post, e-mails, administration and a tricky FCA return. Flipping through investment articles as part of the rebooting process my little grey cells were piqued by an article from Henderson Global Investors (HGI) in one of their investor newsletters, not intended primarily for IFAs. These tend to be pretty basic – that from HGI however deserved some credit for its interesting content.

I would not have expected my first blog of 2014 to have been on bonds but with nothing better to talk about that’s all you are going to get. First some context to my comments on bonds. Whilst there are clear signs of global economic recovery, not least in the UK (no more flat-lining Mr Balls), stockmarkets in January were weighed down by the commencement of tapering of QE – money printing and bond purchases in the US. This has led to repatriation of money from emerging markets to dollar denominated investments. Briefly, a reduction in QE means less bond purchases and hence higher yields or interest rates. This makes dollar denominated US government Treasuries more attractive. The flight of capital from emerging markets triggered a sell-off in equities whilst central banks in South Africa and Turkey raised interest rates sharply to support their currencies which had been in free fall.

Despite these ructions and the potential for any number of other systemic risks to the markets to blow up I sense a generally good mood among investors with equities most definitely being the favoured asset class. Specifically the UK, Europe, smaller companies, miners, Japan have their advocates. I tend to concur despite the headwinds of QE tapering, debt in China and the US debt ceiling. However bonds cannot be discounted and this was the point being made by two leading and respected HGI fixed interest fund managers – Genna Barnard and John Pattullo. They were advocating the benefits of high yield corporate bonds and financial bonds on the basis that companies issuing them were “behaving sensibly,” with lower debt and strong balance sheets. They have not refinanced to aggressively spend on mergers and acquisitions (M&A), special share buybacks or dividends. In conclusion default rates, i.e. the failure of the issuer to make an interest payment or return the principle are likely to remain low.

The relevance of their observations for investors is that high yield and financial bonds remain attractive. Despite economic recovery and growth many commentators consider interest rates, as set by central bankers, will remain low in 2014 and if so high yield will be supported by income hungry investors. As an aside high yield debt is less sensitive to rising interest rates compared to government bonds and investment grade corporates for a number of technical reasons such as their shorter maturities.

Barnard and Pattullo then cited a number of bonds they hold in their portfolios. One from the Automobile Association 9.5% 2019, was yielding 6.2% p.a. at 8/1/14 (Source: Bloomberg). Another bond* from Nationwide Building Society launched in November 2013 with an income yield or coupon of 10.25% p.a. This has rallied and currently yields 8.6% p.a. (also at 8/1/14 from Bloomberg). The reduction in the yield is due to rising bond prices with capital gains for investors who bought at issue.

In conclusion high yield and financial bonds remain attractive for income investors. With 2013 being a good year for this sector, I expect most of the return will come from the coupon rather than capital growth, Combined with the tax free benefits within an ISA, to remind you the 10% tax deducted from dividends from equities is not reclaimable by an ISA fund manager but the 20% tax on interest payments from qualifying bonds is, this could be a good choice for your 2013/14 ISA. Less than two months to go.

*Preferred equity hybrid issue called core capital deferred shares (CCDS)!

This article is intended as general market and investment commentary only and not an invitation to buy specific investments. You should seek individual advice before making investment decisions.