Benstead on Bonds: want growth? Bonds now compete with shares

Long-term investors are told that the stock market is the best place for them, as there is no limit to how large companies can grow, meaning that taken in aggregate returns there outstrip fixed income.

The data backs this up, with UBS numbers showing that since 1900, UK shares have delivered annualised total returns of 9.1% and US shares 9.5%, while corporate bonds have notched up returns of 5.15% in the UK and US.

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In real terms, adjusted for the corrosive impact of inflation, US shares have returned 6.4%, while UK shares have delivered 5.3%. For US and UK corporate bonds, the returns are 1.7% and 1.4%.

But the recent rise in bond yields is putting that theory to the test, according to research from Schroders, the fund manager.

It says that the expected reward for investing in US equities versus bonds has “collapsed”. It looked at the returns that were currently priced into markets by assessing cash-flow forecasts and how expensive shares are, and then compared this with what investors can get if they held bonds to maturity.

The “equity risk premium” can then be calculated as the difference between this forward-looking equity assumption and the risk-free rate, such as the yield on 10-year government bonds.

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For US government bonds, Schroders finds that equities are only expected to return just over 2% more than 10-year Treasuries. Moreover, when compared against corporate bonds, equities are expected to return just under 1% more.

While the data still shows that equities should still perform better, shares come with much more risk and volatility than bonds. This is especially true now as many economists are forecasting a recession in 2024, so the overall risk-reward of bonds looks appealing, according to some investors.

Jon Mawby, co-head of absolute and total return credit at Swiss fund manager Pictet, is one of them. He told me that the returns on offer from the bond market today were the best since the 1990s.

He said: “Even a conservative bond portfolio yields 6%. A 6% yield compares with the long-term return of equities of around 9.5% a year, so two-thirds of the equity market return with the lower risk of bonds. Equities will be very volatile to achieve their return.

“All-in yields are very high and therefore really attractive. Bond portfolios can yield in the high 7% or even 8%, so the return profile versus risk is unprecedented in the last 25 years.”

Mawby is referring to the yield to maturity of individual bonds, which is the annualised return figure from holding a bond to maturity.

He is “very bearish” on the economy, which he says increases the appeal of bonds relative to equities.

He adds: “A weak economy is good for bonds if you look two to three years out, as an economic downturn could lead to lower interest rates and higher bond prices. But if interest rates are higher for longer, then this is also good for bond investors, as you can pick up a high income with limited volatility.”

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Will inflation ruin the bond party?

One key risk, according to Mawby, is if we go back to an environment with much more rampant inflation. Inflation above 10% could create a big bond sell-off again, he argues.

However, Mawby thinks that scenario is unlikely. “Central banks have gone really hard and fast with rate rises, so the likelihood of inflation going back up is lower,” he said.

Another risk to the bond market would be if central banks encouraged a process of “debt deflation”, meaning that they let inflation run hot to decrease the relative value of debt, which is fixed. This would ease the burden on companies, governments and households that have borrowed heavily.

But even if central banks let inflation settle at 3% instead of their traditional 2% target, real (inflation-adjusted) yields would still be positive, says Mawby.

Bonds therefore now offer investors income, the prospect of capital gains and diversification, making them very relevant to investors today.

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Mawby says: “Forward-looking returns from bonds are way better than equities on a volatility adjusted basis. We will look back very positively at this point in five years' time.”

Investment pros back bonds

The positive outlook for bonds has not gone unnoticed by the investment industry. Bank of America’s latest fund manager survey of professional investors found that investors moved to their biggest fixed income overweight since March 2009 and they expect bonds to be the best-performing asset class in 2024.

In total, 94% of investors surveyed said that bonds, stocks, and commodities would outperform cash next year. The survey took place between 3 November and 9 November and covered investors with around $554 billion (£443 billion) in assets.

One reason for the recent optimism is that central banks have likely stopped increasing interest rates, and inflation is showing signs of returning to normal levels.

The latest US inflation figures showed that prices in the world’s largest economy grew just 3.2% on an annualised basis in October, lower than the 3.3% expected.

UK inflation figures also beat expectations, with prices rising 4.6% in the year to October 2023, lower than the 4.8% expected.

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UK-based investors also have the additional appeal of the tax status of gilts, which are free from capital gains tax. Given that lots of low-coupon gilts were issued when rates were near zero, there are plenty of gilts in the market where capital gains is the main source of returns.

Interactive investor customers have been snapping up gilts maturing in the next couple of years to lock in a fixed return, but also buying gilts with longer (including 40-year maturity periods), hoping that their prices will continue to rebound sharply as the inflation and interest rate story turns. 

That leads to a final point – there is a big difference in risk profile between long “duration” gilts, which are very sensitive to the economy/interest rate outlook, and those maturing soon, where the prices will be relatively stable and gradually return to their par value of £100 for gilts as they come closer to their final maturity date.

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Conservative investors looking for “cash-like” income are better served by gilts maturing soon and holding the bonds to maturity, while those who expect bond prices to keep rising will see greater returns from longer maturity gilts, but will also be hurt more if bond prices fall.