Mark Thornton-Smith: Real returns with gilt-free investing

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FEARS are rising that the very safest of asset classes – sovereign debt issued by the UK and US central banks – is likely to fail investors over the coming years.

Cautious-minded investors typically have between 10 and 30 per cent of their money in UK gilts, a form of government debt, with the balance split between cash, corporate bonds, property and equities.

Gilts have historically been seen as a safe haven as they provide a regular income and a known level of capital return. For many investors, this capital certainty has helped to offset the uncertainty of stock market returns.

However, the outlook for gilts has changed dramatically in recent months, giving investors cause to think again about the trade-off between risk and reward.

So why has this happened? As the Eurozone debt crisis has deepened, the financial strength of many large in­stitutions and countries has been called into question, with France being the latest victim of a credit ratings downgrade.

The UK has managed to cling on to its triple-A rating despite the recent warning of a possible downgrade, making UK gilts more attractive to those who are worried that their cash isn’t safe elsewhere. This so-called “flight to safety” has seen demand for gilts – and gilt prices – soar.

Then there’s the impact of the Bank of England’s purchase of £375 billion of assets, primarily gilts, under its 
quantitative easing (QE) programme as a means of injecting liquidity into the economy. This has also created huge demand for gilts and pushed up prices to record levels.

This boom in demand has resulted in gilt yields falling to the lowest levels since records began. That’s because the yield on conventional gilts is fixed, so the yield falls when the price rises and vice versa.

So what can today’s gilt investors expect in terms of returns? A gilt has two main components: the redemption price and the yield, which is paid half-yearly.

If you recently bought a UK gilt with a maturity date of 7 September, 2019, and a coupon of 3.75 per cent on the secondary market, you’d have paid 116.55p. The nominal value – what you will be paid if you hold the stock until 2019 – is 100p. The yield as a percentage of what you have paid for the gilt is, therefore, only 3.2 per cent and if you hold the stock until maturity the redemption yield, taking into account your capital loss, is only 1.2 per cent. Factor in inflation and this is clearly an investment with little chance of providing reasonable returns.

Although cautious investors want a certain degree of capital security, they also want a return that has the potential of beating rates on cash savings and increases in the cost of living. Otherwise why bother investing at all?

It’s clear that cautious investors should think about reviewing their holdings and look at some alternative asset classes and investment vehicles for the “safe haven” element of their portfolio.

Let’s take a look at some of the options. Another traditional cautious investment is a corporate bond, the issuance of a bond by a company in order to raise capital. This sector is currently booming as banks and other institutions look to recapitalise and improve liquidity.

Tesco Plc is offering a coupon of 6 per cent on stock with a redemption date of 14 December, 2029, and a current price of around £1.23. The gross redemption yield is 4.11 per cent – significantly more than what is on offer in the gilts market.

This return does not come without risk: neither the income payments nor capital return are guaranteed and there is currently significant volatility in this sector.

Another possible solution could be the use of structured products within your portfolio. This is the name given to a group of investments that combine two or more underlying assets in order to offer growth or income potential whilst usually offering some degree of capital protection.

For example, you could buy into a product that offers a return of 10 per cent a year if the FTSE 100 index is higher than or level with the start date of the plan, with your capital only at risk if the FTSE 100 was to fall by 50 per cent.

There are also deposit-based structures available that offer 100 per cent capital protection, with up to £85,000 covered by the Financial Services Compensation Scheme. However, these usually offer lower returns than their investment-based counterparts.

Another way of reducing volatility within a portfolio is to use hedging. This term refers to the practice of making an investment that will help protect against potential losses made by another investment.

A basic form of hedging would be to invest in gold. As this is a real, tangible asset that should increase in value as salaries and the cost of living increase, it can be used to hedge against the risk of inflation.

However, the price of gold has not avoided recent volatility and can experience “bubbles” of irrational valuations just like any other asset.

In the current era of sustained volatility, and where previously uncorrelated asset classes have been seen to move in the same direction, it is more important than ever to ensure that your investments are well diversified.

Behavioural finance shows that the emotional stress of financial loss is felt more sharply than the emotional highs of financial gain. Alternative investments have their own risks, so make sure you understand the risks before entrusting professionals to help even the most cautious of investors to achieve real returns in 2013 and beyond.

• Mark Thornton-Smith is a chartered financial planner at Edinburgh-based Cornerstone Asset Management