Asset Allocator’s Soapbox: David Coombs

David Coombs, head of Multi Asset Investments at Rathbone Unit Trust Management, asks if investors should be turning to risk-free assets?

Whilst worries over economic growth and earnings persist, and cash yields next to nothing, investors are directionless. In the main, this has manifested itself in the risk-on/risk-off trade. Whilst we believe that high quality equities offer good value at this point, others are still wary of assuming equity-risk. However, are they right to turn to so-called ‘risk-free’ assets when both have the potential for equity-like volatility ahead?

Gilt yields have now fallen to record lows as fears of deflation again take hold. At the time of writing, ten-year government bonds are trading at yields below 3% – a percentage point lower than at the beginning of the year. Since then, a deceleration of lead economic indicators has renewed fears of another economic downturn, so there is every chance that this could precipitate further falls. Our guess is that in order to secure a more tax-efficient yield, investors will need to take significant duration risk – that is, invest in longer-maturity bonds. Indeed, for a higher-rate taxpayer, to secure a 1% net yield, investors would have to buy bonds maturing in 2027 or beyond. The big risk, of course, is any major jolt could lead to serious erosion of capital, and given this type of environment, there is little room for manoeuvre or error.

While not forecasting any immediate event-risk, a large back-up in yields remains a real threat for gilt investors. Allow me to cast your minds back to 1994, when an unforeseen hike in interest rates by the US Federal Reserve saw bond investors incur equity-like losses. Investors should not forget that policy risk remains high on the agenda, and inflation in the UK is sticky, despite the fall in inflation expectations.

The market’s inflation expectation or ‘breakeven’ rate is measured by the difference between the yield on conventional gilts and the yields on index-linked gilts (linkers) – so the smaller the difference, the lower the expectation for inflation. Breakevens vary by maturity, and at the current time, 10-year breakevens are recording 2.71%, down from 3.24% in April. While this scenario persists, linkers are likely to continue underperforming conventional gilts.

Short-dated linkers still look relatively expensive, and longer-dated linkers carry duration risk. Additionally, if inflation does continue to outpace interest rates, negative real yields will persist, as witnessed back in the 1970s. In this scenario, linkers, despite having negative real yields, are likely to continue outperforming other assets. As for corporates, investment grade bonds continue to look like an attractive alternative to gilts in relative terms; however, credit spreads (the extra yield over gilts) have come in substantially from the peak in 2009. A rise in underlying gilt yields remains a key concern for corporate bond investors. Whilst these risks continue to persist, we see the benefit of investing in bond funds where the manager has the power to manage duration aggressively, possibly even into negative territory.

After all that, you’re probably wondering where we stand on equities? While we remain neutral on the asset class, we continue to overweight high quality blue chips, which are cheap by historical standards, and we remain underweight higher-risk areas, such as Europe. At least with equities, investors are paid to wait.