Evercore Pan Asset

The UK’s Office of Budget Responsibility has recently published its new forecasts. Amongst them is one that deserves more attention than it has received to date. The OBR says the yield on gilts, UK government bonds, will go up from an average 3.8% this year to 4.9% in 2014-15. If inflation stays higher for longer, gilt yields could go up by even more. 

If the OBR are anywhere near right a holder will lose more on the capital value of most bonds than he or she will enjoy in income from holding them. This will come as a shock after a decade when gilts have given decent positive returns, and have outperformed UK and US shares. 
 
Balanced funds are popular these days. Many IFAs and other risk assessors agree with their clients that they need a fund which has a mixture of shares to provide the higher returns at the risk of temporary greater loss of capital in bear markets, and bonds, to provide stability even in dangerous times. This limited losses in 2008, and generated good returns in many of the other years of the last decade. You still hear advisers telling their clients that if they are against too much volatility they should have more in reliable government bonds.
 
If you study the form of various investment classes over longer time periods than just the last ten years, you will see that you can live through a period of several years when you can lose considerable money on bonds. The government bonds today that offer around 4 to 5% have within my time as an investor offered as much as 15% in income. When people think a government is borrowing too much, and when they fear inflation will erode the value of the bond income, they can sell these instruments down to much lower prices than we are now used to. If you hold an undated bond offering 5% at a value of £100, and the market wants long rates to go 10%, the value of your holding will halve as the bond price falls to £50. 
 
So today we need to ask again, is there any danger that UK bonds could fall? Could the OBR be right, and we are heading for a bear market in bonds for several years?
 
On the OBR’s side are several forces. The first is that short term interest rates cannot go any lower. It is only a matter of time before they go up. Rising interest rates is not usually good news for bonds. The second is that inflation has surprised the UK authorities, and is now a lot higher than planned. Current bond interest on many gilts is lower than the inflation rate as measured by the RPI. People’s capital in bonds is being eroded by general inflation. The third is that the government, despite its deficit reduction programme, has to borrow a very large sum over the next few years. The government plans to borrow an extra £482 billion over its assumed five years. This figure has risen by £31 billion in the latest budget. There will be no shortage of supply, after a distorted period when the government bought up £200 billion of its own bonds to keep prices up and rates down. 
 
What could prove the OBR wrong? Only another deep recession and crisis requiring more state purchases of its own debt and continuing low interest rates, or a surge in growth which brought the deficit down much more quickly than imagined without triggering more inflation. 
 
We think it is time to reassess the role of bonds in portfolios. We are keeping our bond money in short instruments or near cash. We are avoiding sovereign debts in countries where there are dangers of fiscal and deficit crises like those affecting Ireland and Greece. We fear that the last decade was the golden age for bonds. They started with high yields, lived through a period of low inflation and quite low interest rates, and finished with government buying and ultra low rates. These conditions we hope are not about to be repeated.

As published in Investment Week