I have written before how government bonds still look expensive to me, relative to the risks of inflation and the potential returns from equities.
The yield to redemption on UK ten-year gilts is 3.66%. That might have done in Jane Austen’s day, but it is pitifully small compared to earlier this decade.
The obvious question is at what yield I’d buy government bonds? At what point does a low but certain return become attractive?
To cut to the chase, my gut feeling is I’d currently be looking for a yield of 5% or more on 10-year gilts before I started buying.
That’s about a percentage point or so above the dividend yield now available on the FTSE 100. The so-called gilt-equity dividend ratio can get much more extreme though, so that doesn’t worry me – a bond yield double or more that of the dividend yield can occur in bull markets for shares.
It’s more the push-me, pull-me inflation debate that’s of concern.
Warning: I do not know where inflation will be in two years. Nobody does. Legendary investor Peter Lynch said if you spent 13 minutes thinking about this stuff, you’ve wasted 10 minutes. I’m just looking for a yield that doesn’t feel like shooting myself in the foot.
On inflation, there are – somewhat incredibly – two conflicting views vying for media attention:
- We face a hyper-inflationary spike caused by quantitative easing (QE) and ultra-low interest rates.
- We’re headed into deflation once the stimulus taps are turned off.
I suspect both extremes sell newspapers in a world still nervous after the economic meltdown of 2008, and that’s why they get so much coverage. The reality will probably be a canceling out and a return to normality.
True, with US unemployment over 10% and the UK apparently still in recession, it’s easy to make a case for deflation.
Nevertheless, if I had to pick a surprise, I’d vote inflation:
- Historically, printing money has tended to cause inflation (Japan is an exception).
- Some economists say the full effect of the QE experiment is yet to be felt.
- The GDP bounceback in output after such a steep decline is likely to be large.
The Bank of England think similarly on inflation, albeit it with a lot of uncertainty.
First, here’s its latest projection, released this week, for GDP (the darker the colour, the more likely the outcome):
Note the sharp bounceback the Bank predicts after the steep decline
You can see this GDP projection followed into its new inflation fan chart. (Note that the base line is the 2% inflation target, not at 0%):
Deflation very unlikely, but the wide fan shows how uncertain the outlook for inflation is
The Bank clearly sees very little chance of deflation (the weak red bar under the 0% level). Admittedly its forecasts have been dire for 18 months, but to be fair these have been chronically unusual times.
Confidently predicting inflation and interest rates is impossible, but to me it seems the risks at least are much more towards inflation than deflation.
Getting a real return when the real world returns
If inflation does reappear, it will eat into the returns of fixed interest and make today’s 3.66% yield look paltry.
The UK’s official inflation target is 2%, with a +/- 1% grace band either side before the Bank of England governor has to write and ‘fess up to the Chancellor.
At my proposed buying level of a 5% yield for gilts, I’d have a 2% buffer zone above the top of the Bank’s band, which would hopefully protect me from a period of above-target inflation.
I’d also consider buying a small amount of US Treasuries, for further diversification albeit at the cost of currency risk.
The U.S. authorities set no inflation target, and yields on US treasuries are generally lower in than UK gilts, due to our generally higher interest rates, the dollar’s status as the world’s reserve currency, and the huge amount of Asian currency hoarding.
Depending on the dollar/pound exchange rate at the time, I’d consider buying 10-year treasuries at a yield above 4.5% (For the record, it’s 3.35% today).
Both these target yields are far below the peak yields of the past couple of decades, and even the highs of the past five to ten years.
This chart shows the 10-year gilt yield over the past decade:
Anything above 5% has been a buying opportunity all decade
Source: Fixed Income Investor
For what would be a small insurance policy against another crash and a diversifier against stock market volatility, I don’t think it’d pay to be too greedy.
Government bonds and asset allocation
How much would I allocate to government bonds? Well, I think we might be into a new bull market for shares, and I don’t think it’s impossible we’ll see average annual double digit stock market returns over the next decade. (No guarantees!)
For that reason – and the fact I don’t need my money right now, so can take a risk – I’d stay mainly in equities.
With government bonds, I agree with Dr Marc ‘Doom’ Faber, who said in a recent print edition of The Financial Times:
“It puzzles me that after a 28-year bull market in long-term US Treasuries, investors are pouring money into bond funds.”
So I wouldn’t go crazy. Ceteris paribus, I’d look towards a holding of around 10 to 20% in government bonds across a range of issues as a decent short term target.
The exact allocation would depend on the valuation of the stock market, with the potential to rebalance or even allocate a higher bond target if the stock market looked frothy – Benjamin Graham style.
The fixed return from the bonds would give some stability to the portfolio, and their special ‘essentially risk-free’ status would provide some insurance against a market crash.
With 60% to 70% of my portfolio still allocated to equities though (the rest being cash, VCTs, and commercial property) I’d still be very aggressively positioned to take advantage of rising share prices (or to suffer any falls!)
Remember, I’m in my 30s. If I was in my 60s, I’d hold more bonds. For other examples of asset allocation, check out these nine easy ETF portfolios.
Note: I’m not an expert, just a keen money blogger, and the musings above are only for your interest – not personal investing advice!
Comments on this entry are closed.
Interesting but the inflation / deflation question almost seems superceeded to me by whether the bond market implodes (perhaps an ugly mix of metaphors) because of the sheer weight of savings-guzzling government pigs at the trough?
I have shorted something once in my life (and regretted it) but this is tempting (tell me I’m an idiot – go on…) using perhaps a short bond ETF?
Some pretty charts! People who think there’s high inflation on the horizon are deluding themselves.
In the US, we’ve been in a 20yr bond bull run, what makes people think inflation will spike with all such a huge output gap? It won’t, no matter how much monetary expansion there is.
You can short bonds if you want, but remember when you short, you PAY a the dividend, so you have to bake in that rate to your effective rate of return.
FS
I did consider shorting US Treasuries back in Christmas, when I wrote this article about what I saw as a bond bubble. It would have been profitable with hindsight, but it’s easy to forget how awful the situation looked back then. I was happy to buy equities on a 10/20 year view if required, but shorting is a whole different ball game.
The yield situation is a lot less crazy now, and shorting to me looks risky with the future so uncertain. As FS alludes to, there’s an easy case to make for saying there’s not lots/any of inflation on the way – the main reason bond markets are so expensive is because nearly all traders are so relaxed about the chances of an inflation spike. (Plus weird technical factors like QE).
My view though is 20 year bull runs tend to end, and inflation is perhaps the least predictable of all unpredictable economic factors. When not if, I think — but I still wouldn’t short – not least as FS says because it’s going to be expensive while you’re wrong! 😉
In terms of pigs at the trough metaphor, which I kind of like, yes, I see your logic. When you think the UK has bought £200 billion or so gilts in the past six months, and the government is going to have to keep issuing more and more debt without that willing buyer (who will eventually turn seller…)
Leaving aside investing, it’s certainly a reason to be pretty sure whatever Government gets in next Spring they’re going to have to slash public spending (otherwise bond markets will impose the hardship for them, via higher interest rates (to reduce consumption etc / i.e. Sterling crisis)).
So yes, I see your logic. But I’ve very rarely shorted anything. Perhaps someone more experienced will come along and add their views! I’m pretty much a long-only share/cash investor.
If inflation is your big worry but you still want to reduce volatility and risk in your portfolio, how about index-linked gilts or Treasuries? Then the yield issue is divorced from the inflation question. (That said, remember that UK index-linked gilts are linked to RPI, not CPI, and RPI is currently negative.)
Thanks FS – that’s exactly what I needed in terms of a contrary view. I’m still not sure about the output gap argument though vis a vis inflation (and I guess we’re not the only ones debating this particular issue at the moment).
Was it Mr Friedman who noted that ‘inflation is everywhere a monetary phenomenon’ (I didn’t think there was a codicil about output gaps)? i.e. there would be a lot of countries with high unemployment who have still had high inflation…
It’s the globally synchronised nature of govt bond issuance that’s interesting to me. There was an astonishing table in Moneyweek in Oct (I think originally from Societe Generale but I can’t find a link to it) that showed the unfunded liabilities plus level of ‘admitted to’ govt debt for about 20 countries that was pretty scary (l’ll try and find it and post from Twitter @smsfs). Actually made Britain middle-ranking in terms of the scale of the problem.
@Mike – Interesting article on this vein in today’s FT by Gillian Tett. She too mentions the currency debasement > crisis > inflation > higher interest rate scenario with respect to government debt.
@Niklas – Thanks, yes, not very appealing at current inflation rates but well worth keeping in mind for the reasons you state. To be honest on the pure inflation view, I’m happy with equities/commercial property at the moment. What I should probably do to reduce volatility a tad is hold more cash… I’m too greedy at the moment!
Here are the official and unofficial govt debt figures for various countries I was referring to above. God knows how you’d calculate them (imagine trying to work out what the UK govt’s potential PFI liabilities are for a start). Japan begins to look positively virtuous and Spain is a model of propriety!
NB the unofficial figures are from 2005 i.e. before some of the recent spending kicked in!
I first read this one way back in the day as a terrified investor (this was still in the teeth of the GFC) who’d found Monevator a year before in 2008 but was still also reading doomer stuff over at the likes of Market Oracle.
Looking back now we know in retrospect that the risk was more to the deflation scenario, albeit not actual deflation but rather disinflation/low inflation and lowish/weak growth.
In the event it took:
– A global pandemic;
– Huge numbers exiting the workforce due to long COVID creating staff shortages;
– Factory shutdowns in China over two years disrupting supply chains;
– Shipping companies simultaneously hiking freight rates to the sky;
– An all out war involving two resource ‘superpowers’ (namely Ukraine/Russia respectively for food/energy);
– 0.1-0.75% UK base rates from 2009-21;
– Supply disruption from the UK leaving both the EU and the single market;
– A cumulative £895 bn of QE in the UK with £450 bn of it undertaken in a matter of mere months during the pandemic;
To finally bring about a few years of elevated inflation, just about cresting into double digits, but seemingly now abating fast with rates having only got up to 5.25% in 2023, less than the 5.75% (IIRC) they got upto before the collapse phase of the GFC.
Taken in the round, the outturn does not support the inflation doomerist stance that was so prevalent when QE started back in 2009. The real problem has been a productivity drought for 15 years and counting since 2008. Neither so much a depression nor a long lasting recession, as were feared in 2008/9, but rather the air going out of the tyres even as the car kept moving. FS probably called it closest in the comments above.