Secrets Of Success: Bonds or equities - a real dilemma for investors

Theodora Zemek is among our better-known fixed-interest fund managers, and she had interesting things to say this week about what is happening in the bond market, her area of expertise. The question she asked was this sensible and timely one: why would anyone in their right mind invest in bonds today, when everyone knows interest rates are on the way up, and many think the equity market is also firmly on a recovery track?

These are two distinct issues, but when many investors are apparently still locked into defensive thinking, fearful of taking risk when risk is being handsomely rewarded, they naturally tend to merge into one. They come together if you are thinking of making a new investment, trying to choose between shares or bonds.

There is a direct but inverse relationship between the level of interest rates and bond prices. Other things being equal, when interest rates fall, bond prices rise and vice versa. If short-term interest rates are set to rise, that is bound to have an adverse effect on the present price of most bonds, though the effect becomes less and less marked the further out you move along the term structure. The Bank of England can affect the cost of short-term money, but the rate on longer- term bonds is set by the markets, not by policymakers, and reflects a wider range of factors.

Since it appears likely the recent 0.25 per cent rise in interest rates will be the first of a series of rises in short-term interest rates, it is easy to argue that bonds are not a good bet at present. As always, it pays to distinguish between whether what you are debating is whether to change your existing holdings or what to do with new money you have to invest.

The great attraction of government bonds, and many corporate bonds, is that they have fixed repayment dates. If the bonds are of high quality, with little credit risk, by holding them to maturity, your capital is certain to be repaid and you will be immune from the impact of changes in official interest rates or bond yields. You will continue to earn the return available when you bought them.

Ms Zemek, who made her name at M&G, and now runs bond funds at New Star, made two key points in her presentation at a seminar organised by Chartwell, the IFA. One was that there are cobwebby myths about bonds which investors need to clear out of their brains, including the notion that you should buy shares for capital growth and bonds for income.

The long-run historical picture does not support this, she said. All the real gains from investing in shares, which have been substantial, have come from the reinvestment of dividends. The rising value of the dividends companies pay delivers the superior returns shares provide in the very long term. But, while the attraction of bonds is mainly the income they provide, there are periods when they can generate substantial capital gains as well, one of which we have just lived through.

The second point Ms Zemek made was that it is simplistic to apply one interest-rate metric to the many types of bonds investors can buy. It is true that interest-rate risk is by far the dominant factor in determining what happens to government bonds (gilts) and other rock-solid issues, such as bonds issued by, say, the World Bank and Shell. Gilt prices have been falling in the past few months but still, Ms Zemek says, look expensive.

Her rule of thumb is not to buy gilts unless they are yielding at least 3 per cent more than the prevailing rate of inflation, which implies that with medium-term gilts now yielding about 5 per cent, against the present inflation rate of 2.9 per cent, they are still some way below her implied comfort level of 6 per cent. In fact, she expects gilt prices to go on falling for a while (as do I), in part because the Chancellor, Gordon Brown, cannot make his sums work without relying on the gilt market to fund the growing deficit on Government spending.

But, when you move beyond the gilt market into the wider reaches of the bond market, the same downward pressures on prices no longer automatically apply. In the corporate bond market, supply and demand and credit risk can have as important an impact on bond prices as the prevailing level and direction of interest rates. Which of these three factors is most dominant can change at different stages in the cycle.

At present, in Ms Zemek's view, there is an interesting paradox in the corporate bond market. This is that there are interesting opportunities to make money in companies whose balance sheets are relatively weak. In general terms, the present stage of economic recovery differs from many in the past, in that companies in general are still (like the consumer and the Government) more heavily burdened with debt than is typical.

This has created a climate in which companies have to pay more attention to the demands of so-called bond-market vigilantes. Angry shareholders forced a change in management at the proposed ITV merger partners, Carlton and Granada, but in many other cases it is the need to keep bondholders sweet that explains why so many companies are forced to sell assets and repay debt before reinvesting in new growth prospects.

As a result, the earnings and interest-rate cover behind corporate bond issues is improving, creating opportunities for price increases, based on an improved credit-risk rating. Ms Zemek's bond fund is up by 10 per cent this year as a result, despite the gloom-mongers' warnings that the climate for corporate bond funds has deteriorated. And the debt overhang implies the recent equity market recovery may be more limited than more bullish observers expect.

What lessons can one draw from this? My own comment would be that Ms Zemek's game is primarily a tactical one. She is clearly right that to make short-term gains from bonds requires careful analysis and nifty footwork. But the longer-term game for bonds will continue to be driven by perceptions of whether the medium- and long-term outlook for inflation remains at, above or below its present levels.

The Bank of England, at least, thinks the threat of outright deflation has receded for now, and that in turn suggests the equity market, which is priced to yield just over 3 per cent at present, need not fall that sharply again, at least this year.

davisbiz@aol.com