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Bonds on verge of ‘swift, bloody fall’

Experts predict pain ahead for UK investors, writes Jeff Salway

FEARS are growing of a bond bubble that could spell trouble for millions of investors who have piled into the market in search of a safe haven.

Experts are lining up to 
forecast a sharp correction in the bond market that would hit pension savers particularly hard as they approach retirement.

UK investors ploughed nearly £6 billion into bond funds last year, Investment Management Association figures show, reflecting impressive returns and an aversion to equities.

That has changed in recent weeks as the stock market 
rally has tempted investors back into equity funds.

Now there’s a rapidly expanding school of thought that believes both government bonds (gilts) and corporate bonds are set for sharp falls.

Haig Bathgate, chief investment officer at Turcan Connell in Edinburgh, said: “We should be doing as much to highlight the bond bubble as possible, as it will be the retail investor who is likely to get 
hit with the losses when they come – which I’m very confident they will.”

So why is there so much doom and gloom around the outlook for gilts and corporate bonds?

The most obvious reason is that with prices having climbed so high, a correction is overdue. The stampede into bond funds – largely a response to stock market turbulence – has had the effect of driving bond prices above their par value and sending their yields in the opposite 
direction.

Alec Stewart, head of asset management at Anderson Strathern in Edinburgh, said: “The uncertainty triggered a flood of money from equity markets into sovereign and investment-grade corporate debt, driving acquisition prices up and yields down.”

The result, he added, is that real yields on UK gilts, German bunds and US treasuries are now negative, threatening investors with capital erosion.

“Historically low corporate bond yields have led to a surge of new issues as corporations seek to repay expensive old debt with cheaper new debt, again driving down the yields available to investors,” said Stewart.

The scenario is exacerbated by the effects of quantitative easing (QE), the Bank of England’s so-called money printing programme. The money produced by the Bank has been used to buy gilts, helping inflate prices and drive yields down (with disastrous implications for retirees buying annuities, which are priced in line with gilt yields).

A recent Turcan Connell 
report on gilts explained that QE means the market is currently abnormal. Gilt prices have been kept artificially high through the purchases, which now account for a third of all gilts in issue, the note said. “It is likely that this programme could be reversed in the near future, leading to a flood of the bonds re-entering the market, which under normal laws of economics would mean a steep decline in the value of these assets,” it added.

The bubble will finally burst when that happens, warned William Hunter, director of Edinburgh-based Hunter Wealth Management.

“With the Bank of England’s QE and the European and US central banks pumping in 
billions a month, the effect is artificially holding up the capital balance sheets of banks and the frail economies of the UK, Europe and the US,” he said. “Bond capital values are way too high and long-term bond yields are too low, which points to a swift correction around the corner. When the market falls, it will be quick and bloody.”

One concern is that when prices start to fall, a flood of withdrawals could cause a 
liquidity crisis – where bonds will be difficult to sell on – and possibly force fund managers to bar investors from taking their money out.

Liquidity is already becoming an issue, according to Bathgate.

“Underlying corporate bond market liquidity is significantly less than it has been historically,” he said, pointing to a 
recent shrinkage in the operations of the investment banks that are the main 
“market makers” in corporate bonds.

Not all commentators believe a correction is on the cards, with some pointing out that it would need an interest rate rise – and that remains a distant prospect.

However, it wouldn’t take a massive plunge to cause problems for pension investors nearing retirement. That’s 
due largely to the practice of lifestyling, where pension funds gradually move investors out of equities and into cash and bonds as they get closer to retirement.

The idea is to limit the potential of losses from which they have little or no time to recover. A large proportion of pension investors in their late fifties and early sixties are in such funds, meaning they 
have significant exposure to bonds. The approach depends on gilts and bonds being low-risk assets, and that’s where the doubts now lie.

“I am short on long-term bonds and gilt funds as I think they will reduce in capital value. Equities and commercial property now provide a safer level of investing with more upside potential,” said Hunter.

Getting out of gilts and bonds entirely isn’t necessarily the answer, however. How 
you respond depends on your circumstances, and it’s worth seeking advice from an IFA as to how you should best position your investments.

While the recent rally has left equities looking fairly 
expensive, Stewart believes they are still good value.

The firm recently made big changes to its balanced portfolio to reflect its concerns over the risk of capital erosion in sovereign debt and investment-grade bonds, the increasing default risk on high-yield bonds and the potential 
consequences of significant 
inflation.

“The cumulative risks of investing in fixed interest mean equities offer greater security of capital,” Stewart argued. “Given that, we are recommending to many of our clients, who are looking for modest growth with a limited downside, that they should be switching into equities now.”

Twitter@ VaughanSalway

 

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