Gilts market slightly tarnished

THE INVESTMENT COLUMN

The gilts market is rounding off this year full of good cheer about prospects for 1996. Returns on gilts have not been as high as those in large overseas government bond markets during the past 12 months. But the recent sharp advance in the UK market shows that investors are confident falling interest rates and low inflation will deliver a rewarding performance next year.

That confidence now looks overdone and a disappointment seems inevitable. All the good news about 1996 has been priced into gilts in the past two months. With hindsight, it would have been better to invest at the end of October.

It is true that there remains plenty of good news about. The inflation outlook remains the best for a generation. Economic growth has slowed to a sustainable pace and the risks are that it will slow even further. Further cuts in base rates are on the cards. The economic environment is just as good abroad, so prospects are favourable for the main overseas bond markets which gilts tend to follow.

However, the market's focus on the good news may be deflecting it from the risks from inflation. One danger comes from increasing pay settlements. Another is that retailers will try to rebuild profit margins if consumer spending picks up as the Chancellor predicted in his Budget a month ago.

There are one or two other potential stumbling blocks. Changes to the structure of the gilts market, starting with the introduction of open gilts repos next week, will help the market in the long run but could cause some choppy trading in the short run. If government borrowing continues to be higher than expected, the extra supply of paper will become a concern. The Bank of England's auction announcement yesterday confirmed that it already has to sell nearly pounds 14bn-worth of stock in the next quarter.

All this is before raising the question of political risk. The stretch before a general election is not usually a peaceful time for gilts investors.

Institutions can opt to switch into more appealing overseas markets. For private investors, there are two attractive strategies. The first is to concentrate on short-dated gilts. Yields of 6.2 to 6.7 per cent for maturities of up to five years are very attractive relative to alternative investments, and there seems to be no danger of Mr Clarke pushing base rates up before the election, even if they might not fall as much as some hope.

The second option is to go for index-linked stocks, which have outperformed other gilts this year. They will deliver an inflation-proofed return and are a good way of hedging against any pessimism on the inflation outlook.

Bonds offer a

punt for nervous

Guaranteed income bonds have been under a cloud for most of this year, waiting for the taxman to decide exactly how the underlying investments that back the guarantee will be treated from next April.

Scottish Widows, which raised pounds 300m in February after guaranteeing a net annual return of 7.4 per cent on a five-year bond, has promised to make good any shortfall caused by the changed tax regime. That makes the Widows offer even better value, given that more recent issues by suppliers such as GAN Life or AIG Life offer lower returns anyway.

Guaranteed stock market bonds which emphasise capital rather than income have tended to take up the running. TSB, now Lloyds TSB, one of the big players in the market, has just introduced its 20th issue.

The capital is guaranteed even if the FT-SE 100 index falls over the next five years; there is no limit on the upside potential; and if the index shows a 25 per cent gain at any time it is locked in to provide a minimum gain.

The increase is calculated on only 95 per cent of the initial investment however, so a 50 per cent rise in the index will generate a return of just 47.5 per cent.

The bond is structured as a single-premium life policy and all growth is normally paid free of tax to standard rate taxpayers, although higher rate payers will be liable for a 15 per cent surcharge. The minimum investment is pounds 2,000.

Another current offer, Hamilton Life's Guaranteed Growth Bond will open next week. In this case a minimum investment of pounds 5,000 guarantees a return of 50 per cent on top of the initial capital after six years. The index must then more than double before investors receive any further increase and even then it is capped at half of any additional rise.

Nervous savers will be drawn by the guarantees from these bonds, which offer a little more spice than Tessas, but true investors will stick to punting on the stock market, which has been a steady outperformer in most recent years.

A quiet start for Lloyds TSB

Trading in Lloyds TSB, the new merged banking group, got off to a sound, if unspectacular, start yesterday. The shares added 4.5p to 343.5p, but the market may not be doing full justice to the potential benefits of Lloyds' double marriage this year.

There is no question Sir Brian Pitman, Lloyds' chief executive, has set himself a formidable task. Integrating Cheltenham & Gloucester, the former building society was always going to be difficult, but it will be nothing compared with TSB. The bank duplicates Lloyds in nearly everything it does, while its culture could hardly be more different, having been based in the traditions of the savings bank movement.

But the new grouping starts off as one of the top three players in several key areas, including the mortgage, retail banking and corporate lending markets. Its lending will give it a market share of 12 per cent and its branch network 18 per cent of the total for banks and building societies.

There are two weapons Mr Pitman can use to lever off this base. The focus so far has been on cost-cutting. Lloyds has forecast that savings will hit pounds 350m a year by the end of the century. However, that estimate is almost certain to be conservative: based on US bank mergers, SBC Warburg suggests another pounds 100m could be found, particularly if Parliament passes the required private member's Bill in 1997.

Equally important to the Lloyds mergers will be successful brand management. The new group will have a powerful array of brands at its disposal. C&G commands an excellent name in mortgages, while TSB is building a reputation for value-for-money, no-frills banking products and Lloyds retains its attractions for a wealthier, more professional customer base.

Based on SBC Warburg's forecast of profits of pounds 2.36bn in 1996, the shares stand on a forward multiple of 12. That suggests Lloyds TSB should remain a core holding in any portfolio.