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Weekend reading: Did George Osborne just tell us to sell bonds?

Weekend reading

A few good reads from around the web.

When a politician goes one way on an investment, it’s very often a good idea to run the other:

Politicians are not investors or traders

Consider Gordon Brown’s sale of Britain’s gold, which marked the bottom of the market ahead of a decade in which it rose five-fold.

Politicians first priority is to get reelected

Maybe that’s fair enough in a democracy. But it inevitably leads to short-term gains and long-term pains.

Politicians usually put national interests ahead of individual investors

Again, as it should be. But don’t say you weren’t warned!

For example, let’s imagine you’d done the right thing, saved for your old age, and bought an annuity with your retirement pot, while keeping some cash back for emergencies.

Instead of rewarding your good behaviour, governments across the Western world have chosen to bail out the indebted and feckless via ultra-low interest rates, as a byproduct of staving off an even worse financial downturn.

I don’t think they’ve made the wrong decision, from their point of view, and perhaps the nation’s, especially in the short-term, when moral hazard can be conveniently chucked out the window. But if you’re a pensioner living on a fixed income – or indeed anyone without debts to be eroded by inflation – you’re paying for it.

It’s in this spirit that we should consider Chancellor George Osborne’s plans for the UK to issue 100-year government bonds (gilts).

The BBC reports:

In his Budget next week, Chancellor George Osborne will announce that he will consult on creating a new “super-long” gilt that could even be issued with no set redemption date.

The theory is that these super long-term gilts would allow the government to lock in the current record low interest rate for a very long time.

If the bond proved popular with investors, future governments would pay less debt interest for years to come.

I think this is a great idea, from George Osborne’s perspective. In fact, I’ve been suggesting to friends for months that governments (and companies for that matter) should take full advantage of the past three years of bearish fear and insecurity that has driven bond yields to record lows.

“When the ducks quack, feed ’em,” as they used to say on Wall Street.

I should think bond yields being higher at some point in the next 100 years or so is one of the best bets you could make, just after “always back the broker.”

An even better bet is that 100-year bonds will provide a derisory return, once inflation is taken into account, although we do not know the coupon yet so it’s hard to be entirely confident. (Even I’d consider putting some money into a 100-year bond paying over 6%, but that’s nothing like what will be offered!)

Of course, accurately valuing the returns due from a 100-year bond is the stuff of fantasy. It relies on benign expectations for interest rates that hold for a century.

Consider all the events of the past 100 years – that’s going back to before World War 1, remember – and you’ll see how barmy it would be to buy such a bond at any sort of low yield.

There are already undated long-term gilts on the market that prove my point, as The Telegraph also warns:

Gilts – or bonds issued by the British Government – may appear to be as safe as the Bank of England. But they are vulnerable to any increase in inflation in the period before they are redeemed because this will reduce the real value or purchasing power of both the coupon or income they pay and their maturity value on redemption.

There is nothing theoretical about this – as patriotic investors who bought gilts issued to pay for the First World War found to their cost. Andrew Bell, chief executive of the giant Witan Investment Trust, calculated that £100 invested in War Loan stock nearly a century ago would be worth little more than £2 today.

That calculation takes account of the reduction in the purchasing power of money since 1914.

For nearly as long as I’ve been investing, undated government bonds have been presented as a sort of curiosity piece, showing how silly investors were in olden times. Only recently has this image been undone, as the price of Consols and other irredeemable bonds have soared in the wake of the financial crisis.

Funny how purportedly obvious, inarguable truths are turned on their head if you hang around long enough in investing.

In that spirit, I should note that it’s not impossible these 100-year bonds will be a great buy. But I don’t think it’s remotely likely.

The end of the great bond bull market?

Perhaps I’m one of the last acolytes still infected by the ‘cult of equity’, and I’m ignoring for instance the persistently low bond yields that followed Japan’s bubble bursting in the late 1980s.

If so, I’m in good company. Only a few weeks ago Warren Buffett warned that these ultra-low bond yields were dangerous assets ready to blow.

The Economist also saw signs this week that the bond cycle may finally be turning, asking:

Are we witnessing one of those historic turning points in markets, on a par with March 2000 (when the dotcom bubble burst) or March 2009 (the post-Lehman low)?

The issue is not so much with equities which are continuing the stop-start recovery that has lasted for three years. The interesting issue is the bond market.

Remember, these are extraordinary weird times. Look at the blue line in this graph (from The Finance Blog):


That blue line – representing flat near-zero interest rates from the Bank of England – is bizarre. It’s so odd that you could stretch that graph back 300 years, and you wouldn’t see another period that looks remotely like it.

In contrast, you only need to go back as far as the lifecycle of a typical Hollywood trilogy to see interest rates over 5%.

I wouldn’t be surprised if these 100-year bonds prove to be as blatantly signalling a change in the market as the P/E of the NASDAQ in the dotcom boom, or Gordon Brown offloading our gold reserves in the depths of its bear market.

Many semi-active investors like me have already voted with our feet, and long ago moved money out of government bonds accordingly. That proved a terrible decision in 2011, when gilts soared, but I’m confident it’ll prove the right decision in the medium to long-term.

Passive investors face a dilemma. Many portfolios have a set allocation of fixed interest in bonds.

If they decide to hold and face the music, I wouldn’t blame them. The whole point of the strategy is to avoid being wrong-footed by ‘obvious market calls’.

An alternative for the more flexible might be to cut your government bond exposure, but increase your allocation of special bonus interest rate chasing cash.

Institutions can’t move a few tens of thousands into special fixed rate savings bonds paying say 4%, but we can. I’d suggest you consider using that flexibility, and avoiding the low-yield bond menace.

True, cash isn’t equivalent to bonds, and it won’t rise if the stock market crashes. One response might be to hold more cash than you otherwise would, to reduce your risk in that way instead.

By George, I think he’s got it

As usual, The Daily Mail is utterly wrong on these bonds. It argues Osborne is trying to offload our debts to future generations.

The truth is we’ve already incurred these massive debts, whether explicitly or implicitly (such as through State pension commitments). The question is what interest rate we pay for those debts.

If George Osborne can get suckers to buy his 100-year promise at a multi-century low interest rate, I salute him as a taxpayer.

A cynic might also note that compelling pension funds to own government bonds – and then popularising the canard that they must ‘match their liabilities’ as an aspiration that makes a 0.5% real return look like a triumph, even if it makes such pensions essentially unaffordable for most in the meantime – won’t hurt his sales pitch any.

From the investing blogs

Book of the week: Carmen Reinhart and Ken Rogoff’s 2011 splendid sortie into financial history, This Time Is Different, is getting a lot of fresh exposure after the former aired her views about the likelihood of governments trying to inflate away their national debts, and impoverishing savers as a result.

Mainstream media money

  • The American economy: Unmired at last – Economist
  • 45 years of rising dividends – The Motley Fool
  • Growing financial rift between young and old – FT
  • Income prospects are brighter abroad – FT
  • Do your bit to distort the UK economy – Merryn/FT
  • FSA intervenes on interest-only time bomb – FT
  • ISAs versus pensions – The Independent
  • Shutting down stamp duty tax avoidance – Telegraph
  • Damien Hirst and the great art market heist – Guardian
  • £9,000 in university fees… and then the costs begin – Guardian

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{ 28 comments… add one }
  • 1 The Investor March 17, 2012, 12:17 pm

    Apologies to anyone who received a slightly earlier version of today’s post in their email.

    I wrote much more about the bonds than I’d planned to — pushing me to the brink of the time deadline for Saturday morning publishing — and then the automatic emailer snatched it out of my hands before I had a chance to correct the typos!

    Annoying, really, since thousands receive the email, whereas only hundreds read the post here on the site on Saturday morning!

    In fact, they won’t even read this errata, and presumably think I woke up drunk. 🙁

  • 2 Niklas Smith March 17, 2012, 1:04 pm

    Maybe I’m the only one, but I always click on the link in the e-mail to take me to blog and archive the e-mail immediately; I prefer reading on a webpage (at least a nicely designed one like yours!).

    On to the main subject, and I’ve always been curious as to why governments don’t issue perpetual bonds (consols) anymore; in the Victorian era they were so popular that companies invented preference shares to create in instrument that mimicked consols. And bankers of the time knew that in a panic the only securities anyone was willing to buy were consols – even Exchequer bills (short-term government debt) could become illiquid.

    Is the explanation that in those days long-term expected inflation was zero (thanks to the gold standard), whereas nowadays we expect positive but uncertain inflation, which adds to the risk of long bonds?

    Regarding politicians as lousy investment advisors, you need go no further than the pronouncements of Irish leaders such as Bertie Ahern during the run up to Irelands housing and banking crash: they all said (in so many words) that buying a house was a good idea and would make people lots of money! Anyone who disagreed was accused of “talking down the economy”. There are some hair-raising examples in Simon Carswell’s book Anglo Republic.

  • 3 gadgetmind March 17, 2012, 1:21 pm

    I come to the site via the RSS feed so always see your latest words of wisdom.

    I’m ditching the last of our gilts next week, but still hold corporate bonds and strategic bonds. Should I be worried?

    I also hold Personal Assets, RIT and Ruffer, but I have a feeling that they know what they are doing!

  • 4 The Investor March 17, 2012, 1:47 pm

    @gadgetmind — If I ran any kind of public multi asset fund I would definitely hold some sort of government bond allocation. The diversification benefits are strong. But I think an active private investor ready to take on some risk can be bolder (perhaps offsetting some of the risk via more cash as I say).

  • 5 The Investor March 17, 2012, 1:54 pm

    @Niklas — Great to hear from you, and a great bit of history there! 🙂

    I think you’ve answered your own question, though. Modern investors were badly burned by fixed interest in the 70s, for example, and more insidiously before that.

    With the mentality of today’s market, where three years ago is ancient history and three months ahead is ‘medium terms’, we might as well be discussing unicorns.

  • 6 saveonarola March 17, 2012, 1:58 pm

    I’ve recently embarked on an index funds, dripfeeding strategy, with an asset allocation roughly 70% equities and 30% bonds (15% gilts, 8% corporate bonds, 7% index-linked gilts). To calm my nerves, I tell myself that a falling gilt price will mean that I’ll buy at a lower price each month, even if my (small) existing investment tanks. What else can a committed passive investor do?!?

  • 7 gadgetmind March 17, 2012, 2:01 pm

    Interestingly, the fact sheets for the strategic bonds funds (and for an “Balanced Index Enhanced Fund of Funds” that I hold in my GPP) all seem to be tilted towards corporate bonds and short-dated gilts.

    Who is holding the long-dated gilts?

  • 8 The Investor March 17, 2012, 3:35 pm

    Yes, very short gilts are a totally different matter — much more like cash.

  • 9 gadgetmind March 17, 2012, 4:13 pm

    One of the strategic bond funds I hold has got negative gilt durations, so is shorting them. This is what finally convinced me to go with that fund alongside my bond ETFs.

  • 10 Niklas Smith March 17, 2012, 5:11 pm

    @gadgetmind: “Who is holding the long-dated gilts?”

    Pension funds, I suspect. In particular they hoover up long index-linked gilts because these match their liabilities (pensions for people retiring 20-30 years hence). The painfully large deficits that many defined benefit pension funds now have (forcing the companies behind them to make extra contributions at a time when most companies would prefer to keep every spare penny) make that an attractively low-risk strategy, but also a low-return one.

  • 11 The Investor March 17, 2012, 6:54 pm

    In my opinion, UK pension funds running down their equity holdings over the past decade is a great opportunity for those of us who are prepared to take the volatility of shares.

    I’ll take the FTSE 100 / income ITs / quality blue chips yielding 3-4% and paying a very likely real-terms rising dividend for the next 30 years, and who cares if the actual shares never go up in price again?

    Pension funds with 30-50 year time horizons are exactly the participants who should be holding equities. More bear mania = our good luck.

  • 12 gadgetmind March 17, 2012, 7:38 pm

    @TI – I’m a bit of an equity hog, and am doing most of what you list other than income ITs. For UK income, I’m happy to hold directly, but my global income is rather limited. It’s currently a small holding in a JP Morgan Global Equity Income fund that transferred into my ISA from an IFA-concocted portfolio and which didn’t seem as half-baked as most of his other ideas.

    Note to self: Look closely at global equity income exposure!

    BTW, 3-5% is a tad pessimistic. Even now, you should be able to get around 5% for a well-balanced portfolio and still have a fair bit of growth potential. There are already signs that the hot money is thundering towards cyclicals, so high-yield non-cyclicals could fall out of fashion, which is always nice.

  • 13 The Investor March 17, 2012, 8:34 pm

    @gadgetmind — Re: the yield, yes, depends how you buy your income.

    One of the best and most knowledgeable income investors I know is pretty sceptical of the ‘HYP’ approach and always includes a fair bit lower yielding dividend growth in the mix. Hence my 3-5%. I reckon my demo hyp on Monevator must be around 4.5% forward yield now.

    BTW: One interesting IT for foreign income is JEMI for emerging market exposure. Pretty unproven mind, so I’d suggest only a modest allocation.

  • 14 gadgetmind March 17, 2012, 8:54 pm

    I’m watching JEMI, and a few other income diversification holdings. I’ll probably pick some up in an ISA next tax year.

    As it happens,. I have some unlikely HYP candidates including a few FTSE 250 companies – I couldn’t resist the price of WS Atkins six months back and am up 50% capital and the yield looks tasty and solid.

    It all depends on your age, I guess; I’m about to have my last birthday starting with a 4,, and am expecting/projecting/hoping to retire at 55, so I’m increasingly looking for reliable rather than potential.

    I’ve also got some hairy-arsed tech share holdings to keep me awake at night, and kind of need the rest of my portfolio to smooth things out.

  • 15 Peter March 18, 2012, 8:11 am

    Talking about JEMI, I have allocated some money to the state street emerging market income index fund. Code EDIV alternatively there is a I share DVYE, both passive vehicles.

  • 16 gadgetmind March 18, 2012, 8:54 am

    @Peter – I’m always very cautious regards mechanical stock picking based on yield. I don’t know what algorithm state street (or the underlying index) uses, but I’d hope it’s one that avoids over-exposure to single companies and sectors.

  • 17 OldPro March 18, 2012, 11:57 am

    Did any of you indexing boys read the “hubble bubble” article in the PSY-FI blog in the list… what are your thoughts if I may be so bold…?

    Always be suspicious of a free lunch…

  • 18 Peter March 18, 2012, 2:08 pm

    I had the same concerns but the state street etf is based on 3 yr dividend growth, yield and liquidity criteria. Also, I believe individual shares are capped around 4% and sectors and countries at around 25%. It is physical, optimisation stratedgy.(not synthetic). A US counterpart eft has been around since 2006 I believe. I don’t know about the I shares one.

  • 19 dean March 18, 2012, 2:35 pm

    I must confess I don’t really understand bonds, perhaps because I find them a bit dull. I can understand a little about Tescos, BP, Pizza Hut and suchlike so I tend to stick with shares and index funds composed of them. But if there is some sort of crash or crisis regarding bonds, as you allude to in your article, is that the time to start thinking of buying ’em?

  • 20 NumberMuncher March 18, 2012, 5:04 pm

    NumberMuncher’s the name, number crunching’s the game… The risk (duration) of bond holdings increases as term gets longer and yield gets lower, so a 100 year bond at historic low yields is the fixed-income equivalent of some warm nitroglycerin in a food mixer. A 1% yield increase in a ten year gilt at current yields will hit the value of your holding by about 8p in the pound. A 4% 100 year gilt would lose nearly 20% of its value if its yield rose to 5%. There is a case for a certain amount of gilt holdings, but I’d wait for an index linker at a decent real yield before I got any way enthusiastic about them. To add to your weekend reading list: this week’s Economist article on the equity risk premium is relevant to this discussion and Gavyn Davies in the FT on the latest bond sell-off gives a good medium term view.

  • 21 Hannibal March 19, 2012, 8:47 am

    Very interesting post and comments. The perpetual ‘Consols’ gilts (CN4) are quite interesting. On Friday they were yielding a perhaps surprising 4.4% – which might be an attractive base risk-free return for some portfolios (ignoring inflation for the moment). This yield dipped recently (i.e. the price increased) and I sold out, for a profit. But if the yield increases further this might be a signal to buy again. Why? Because of its insurance value – if financial markets stutter again, it is a safe haven (as noted in one of your comments).

    On inflation, surely the expectation is that it will fall to below this rate?

  • 22 The Investor March 19, 2012, 2:59 pm

    @Dean, I’ve written a bit about corporate bonds before that goes into pricing and so forth in an introductory fashion:


    I’ve also written about gilts:


    Hope those are useful.

    @NumberMuncher – Yes, an image of picking up a cat by the end of a very long tail comes to mind!

  • 23 gadgetmind March 19, 2012, 4:40 pm

    @Peter – thanks for the info on the State Street ETF. Well worth me having a proper look!

  • 24 Dave March 19, 2012, 5:59 pm

    Heh. Gold is surely in a massive bubble, bonds are about to tank, and equities are stuttering along in fits and starts… no doubt to be brought low in the same cataclysm (although God knows where the money will be going if that’s the case).

    Why can’t life be simple? Unfortunately it’s impossible to take up a short term high-interest sweetener on cash from a high-street bank, within an ISA…

  • 25 gadgetmind March 19, 2012, 6:28 pm

    @Dave – if you feel like that, buy bullets and MREs. I’m 75%+ in equities and am sleeping soundly.

  • 26 The Investor March 19, 2012, 7:30 pm

    @Dave – If life was simple, we’d all be rich — and who would go out and do the work? 😉

    That said, “fits and starts” equities have delivered 70-100% over the past three years, even in the UK including reinvested dividends. As I wrote last week, it’s been a dream time to be an equity investor with a sensible time horizon. (We should be so lucky to see shares double again in three years from here…!)

    Regarding cash, it’s pretty easy to get around 3% or so with a one-year fixed rate bond, while say Scottish Widows will give you 4% on a three-year lock up.

    I don’t say you’re going to get rich on that, but it compares very well to the c.0.75% redemption yield on three-year gilts currently. Even ten-year gilts are only paying about 2.4%, although the yield on offer has been rising as the gilt price falls (it was 2.2% a couple of weeks ago).

    I think given those yield comparisons, locking away cash is a very credible alternative to gilts for individual private investors in these strange times, albeit as I say above certainly not a pure like-for-like swap.

  • 27 gadgetmind March 20, 2012, 9:19 am

    The bulk of my cash is currently in NS&I bonds but I also have some in cash ISAs earning 4% and some “walking around money” in a 3.15% instant access account.

    Everything else is invested.

  • 28 Dave March 20, 2012, 3:06 pm

    “(We should be so lucky to see shares double again in three years from here…!)”

    Quite… it’s *been* a great time to be invested in shares!

    Just a grump on my part really – of course, if it was obvious what was going to happen, the prices would already reflect that and no advantage could be had (I often think that investing is basically like gambling).

    One thing I’m finding difficult about being passive is that there is plenty of opinion that for asset X, now is a really bad time to be in X, and I’m strangely loath to put new money in buying high, while at the same time acknowledging that I have no idea what is really high, and what isn’t…

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