Little value in gilts
In light of the lacklustre growth outlook in the west, and to balance the tight fiscal policies being run in many markets, interest rates are set to be kept at historically low levels throughout this year and well into next. However, despite this helpful interest rate backdrop we see little value in core government bonds. US, UK and German bonds found support from their ‘safe haven’ status last year, but they now offer such low yields that there is limited scope for healthy positive total returns. Moreover, with yields below the rate of inflation in many areas, there is a heightened risk of losses in real terms. At the same time, the US and UK in particular are also struggling with very high debt levels which make their low yields hard to justify over the long term.
Know the risks
So, where will income-hungry investors turn? Investors can access yield in a number of ways, but it is important to balance potential returns against the risks involved. For example, 10-year Greek debt at a redemption yield of 39% might look compelling, but there is a good reason why the yield is that high – namely the very significant risk of default.
For many, emerging market and corporate bonds represent a more attractive option. The yields here are nowhere near as high as the Greek debt mentioned above, but they are still attractive relative to gilts. More importantly, they are coupled in many areas with robust fundamentals. Indeed, the majority of emerging market sovereigns boast much stronger finances than their developed world peers. Meanwhile, well-managed companies from across the sector spectrum have strengthened their balance sheets over the past three years, helping to limit the chance of a significant spike in corporate defaults even if growth slows sharply. We believe that the excess yields offered by corporate and emerging market bonds overstate the risks involved. As such, we continue to prefer these areas within fixed income.
Beyond bonds
Looking to other asset classes, the yield premium offered by UK commercial property over gilts is also at historically wide levels and, although some areas of the property market are likely to suffer headwinds in 2012, the yield should be well underpinned. Finally, the dividend yield on many good quality companies’ shares is even higher than the corresponding corporate bonds. Some commentators have questioned the sustainability of these dividends but payout ratios are historically low, which means that we are unlikely to see dividend cuts on the scale that we witnessed in 2008. This, together with the scope for capital growth over the long term, is likely to see equity income products remain in favour.
Summary – look for long-term value
When the daily news flow is as absorbing as it has been, it is always tempting to focus on the short term. However, the way to add real value is to block out the noise and take advantage of short-term distortions to invest in assets that have become undervalued. Despite the lacklustre economic outlook in the developed world, our fundamental analysis suggests that the best value is to be found in risk assets. From a fixed income perspective this means corporate, high yield and emerging market bonds. We are also seeing good value in quality equities. This does not feel like an environment in which it is appropriate to take on too much risk. Nevertheless, recent uncertainties have left risk assets looking underpriced, and bonds or equities from well capitalised companies should outperform over the long term.
Mark Burgess is Chief Investment Officer at Threadneedle Investments.