The financial markets have always been a battleground between the two dominant investor sentiments, namely fear and greed. When the latter is prevalent investors turn away from the lure of promising returns and head for investments where return of capital can be relied upon, but when times are really bad, government bonds often benefit.
This flight to quality has been under way in government bonds since last summer, and has been particularly evident in the US. Short-dated (three-month) government bills have seen massive inflows of 'fear' money, pushing down the yield to an eye-watering 0.02 per cent a year on the 17th of last month. Effectively, the buyers were prepared to completely give up the concept of return on their money in exchange for protection of capital.
Similar flows have been seen in the UK. British government bonds, also known as gilts, have the full backing of the government and represent effectively zero risk of non-repayment. Comforted by a track record of repayment stretching back to William III in 1694, both institutional and private investors have been moving money into the gilt market.
Shorter dates are best
For investors looking for safety and liquidity, and who wish to purchase the gilts directly, rather than through a fund, short-dated issues offer the best option. These bonds have seen strong demand over the past few weeks, pushing up prices and lowering yields commensurately. For example, the UK Gilt 4 per cent, maturing March 2009, is priced at 100.4p, equivalent to an annualised yield of 3 per cent. Perhaps slightly better value is the 4.75 per cent June 2010; at a price of 101.82p, the yield on this gilt is equivalent to 3.6 per cent a year. Not cheap, compared with the 6 per cent per annum or more available on bank deposits, but effectively investors are paying for quality.
There are alternatives to gilts. A good choice is the EIB 4.25 per cent December 2010 bond. This sterling-denominated eurobond is issued by the AAA-rated European Investment Bank (EIB). This supranational development bank was created by the treaty of Rome in 1957 and is owned by the European member states, effectively a multiple government guarantee. At a price of 99.45p and a yield of 4.5 per cent, this bond has the advantage of a below-par price (thus preventing any erosion of capital) and a higher yield than the gilt. The liquidity will be slightly inferior to gilts, but all in all the bond represents good value in the current environment.
And what of other bonds? Traditionally, bonds issued by banks and other highly rated organisations have been seen as a secure home for funds. However, we live in strange times and even triple-A credits such as General Electric are yielding 9-10 per cent. These bonds have been sold off heavily and are now effectively priced as 'junk' by the market. While there is certainly risk attached, on balance, I suspect that some of these assets will be seen as bargains in the future.
For more suggestions see our weekly bond feature, which appears exclusively on the IC website...
