The time looks about right for a shift away from bonds

Bond yields remain very low by historical standards, writes John Hildebrand

John Hildebrand
John Hildebrand

Sometimes investors wait until there is a turn in a market before making a significant change to their asset mix. So far in 2013, UK government bonds are down by 2.5 per cent and UK equities are up by 8 per cent - so this seems like such a moment.

But this time last year, government bonds had fallen by 2.5 per cent and equities had risen by 7 per cent. In the following three months to the end of May 2012, markets went into reverse, with bonds up 4 per cent and UK equities down 8 per cent. So it is difficult to be sure whether now is a good time to make a switch out of government bonds and into other investment assets. What is the case for doing so?

Such bonds should provide a return roughly equivalent to the nominal growth in the economy, with long-term interest rates usually bearing some reference to this figure. If growth picks up, investors fear inflation and want to generate a higher return to protect themselves against the rise in prices. Consequently, bond prices fall and yields rise.

Low growth

Economic growth has remained stubbornly low over the past few years and the Bank of England has been a willing buyer of bonds. So even though they have risen recently, bond yields remain very low by historical measures.

The main area of the bond curve investors look at is the 10-year bond. At present, 10-year gilts - or government bonds - yield 2.2 per cent. The rate of inflation, as highlighted by the retail price index, is close to 3 per cent, so a move out of bonds on valuation grounds still looks timely.

Inflation has been above the Bank of England's 2 per cent target for most of the past five years, and seems likely to remain above that level for some time. The next governor of the Bank of England, Mark Carney, has said that the bank, if it is to foster growth, should be willing to accept a temporary increase in the rate of inflation and consider targeting nominal GDP.

Protection against inflation

This has led to a belief that there will be a further expansion in the money supply and a weaker pound, which will lead to an increasing need for investors to seek more protection against inflation.

This suggests that now is a good time to switch out of bonds, whose income is fixed in nominal terms, into real assets such as equities. Shares are 'real' assets because the profits, and therefore income from them, should rise as prices pick up. Consequently, they offer an attractive alternative to government bonds.

In general, moving away from bonds leads to a more volatile asset mix. However, the yield on UK equities of 3.5 per cent is high and shares still look fair value - cheap, even - on most measures.

Bonds have yielded less than 3 per cent only a couple of times in the past 40 years. So this remains a good time to rebalance one's asset mix and a charity making such a switch should also find that it will generate a higher income.

John Hildebrand, an investment manager at Investec Wealth & Investment

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