The tide is going out - is your portfolio covered?

A year ago, I wrote a MoneyWeek article called Bonds, the end of an era'. I warned that there was no way the bond bull market could last for ever. At some point yields were going to start rising and prices falling. Today it seems my predictions are coming good. The yield on ten-year UK government bonds (gilts) has risen steadily and prices have fallen as a result. In June 2006, the ten-year gilt yielded 4.6%. Now it is at 5.54%, a seven-year high (see chart 1 below).

But it isn't just yields on long-dated bonds that are rising. Short-term interest rates are on the up too. The Bank of England's Monetary Policy Committee (MPC) has just hiked the UK base rate (the rate at which the central bank lends to other banks, and on which all our personal debt is priced) to a six-year high of 5.75%. Most analysts expect it to be 6% before the end of the year, and some are even predicting 6.5%. After all, it's not as if household borrowing has slowed yet, while UK factory production is at its highest in almost six years.

The apparent lack of a slowdown is a mystery to some, but it makes sense to me. While nominal interest rates may have been rising for some time, real interest rates (the nominal rate minus inflation) are still very low, particularly if you measure inflation using the retail price index (RPI). A variation on this index, RPIX (RPI excluding mortgage payments), used to be the Bank of England's official inflation measure, until late 2003 when Gordon Brown, then chancellor, switched it to the consumer price index (CPI).

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Brown made this switch ostensibly to harmonise our inflation measure with Europe's, no doubt partly as a sop to Tony Blair's broken dream of joining the eurozone. But the cynical might think he had a few other things in mind too. The CPI measure of inflation had consistently under-reported price rises compared with RPI. So by making the switch, Brown wasn't dealing with the problem of rising prices he was just fiddling things to make the MPC, the press and wage-bargainers think inflation wasn't a serious threat, that rates could stay low and that (and this is the real key) Britain's economic boom could go on and on.

But as the two measures have diverged, people have started paying attention to RPI again especially the trade unions, who unsurprisingly regard it as a better measure of the true cost of living. So what is RPI telling us about where interest rates are heading? Well, with RPI now running at 4.3% and base rates now at 5.75%, real interest rates are 1.45% (5.75 4.3). This is about half the normal' historical level of 3%. So if the MPC really wants to head off inflation, history suggests it needs to raise rates to 7.3% (4.3 + 3) see chart 2. That suggests the equilibrium rate of interest may be closer to 7.5% than 6.5%, a level that none but the most aggressive inflation hawks are currently predicting. Is inflation scaring the bond market?

Look at it like this, and you might think that the reason the bond market is so weak is because investors see inflation as a genuine threat. That should be the case but I'm not sure it is. Firstly, if inflation was the real worry, then we should be seeing a huge rise in index-linked bonds, which protect against rising prices. We aren't. Secondly, real gilt yields are still at almost record lows. If people are really scared of inflation that doesn't make any sense at all they should be demanding higher yields to compensate.

And yet gilt yields adjusted for RPI are just 1%, lower than at any time during the past 25 years (other than the depths of the 1990 recession). Adjusted for CPI, they're a less extreme 2.5% in real terms. But even this is still very low. Look at chart 3, which shows three prior periods when real yields were this low. The first, marked A, was the house price crash and recession of 1990-1991; the second, marked B, the Russian debt default and the LTCM bail-out of 1998; and the third, labelled C, marked the dotcom crash. The horizontal blue line on the chart underlines the fact that usually it's only recessionary shocks that account for risk-free real yields being so low. Right now, there's no such shock. Instead, on the face of it, there is a huge risk of inflation. So why are we seeing an extended period of ultra-low real gilt yields?

Recession is the real fear

By keeping real yields this low, the gilt market seems to be telling us this: not that the economy is stronger than we think and vulnerable to inflation, but that it's weaker and vulnerable to slower growth and weaker prices. It would appear the bond market has seen what Gordon Brown's legacy has been (a dodgy housing market, high levels of personal debt and the risk of falling consumption) and doesn't like the look of it. The market may also have noticed something I think our central bankers pay too little attention to. That's the fact that the rate of economic growth in the UK has been higher than the real interest rate for the last three years. This was also the case from the late 1950s until 1981. Chart 4 shows that from 1959 until 1981 (green vertical line), nominal GDP growth rates were almost always higher than interest rates. This meant that monetary conditions were almost always too accommodative. The good news was slightly better nominal growth; the bad news, ever higher inflation to erode it away. Eventually everyone had had enough and rates from 1981 onwards were consistently above nominal growth.

This put something of a dampener on short-term growth, but it allowed an almost unbroken period of falling interest rates as inflation was driven right out of the system. From then until a few years ago monetary discipline was the single biggest factor in creating and maintaining what Alan Greenspan called the Great Moderation'. That Moderation (characterised by an extended economic boom, low inflation, rising house and other asset prices and moderate wage demands) is now under threat due to the relaxing of monetary policy since 2003. In June 2002, RPI was just a smidge over 1% and CPI was only 0.6%. Now they're already at 4.3% and 2.5% respectively. It doesn't bode well.

The world and Whitehall

Still, there's more to bond markets than the parochial affairs of Whitehall. In the last few weeks bond yields have jumped everywhere and that's not due to concerns about recession in the UK. So what's it about? The first place to look is the US Treasury market, which reacts to the outlook for America's economy. In this market there are currently two types of investors. Those who believe the official line that the economy will reaccelerate in the second half of the year are worried about inflation. They think rates will rise and Treasury bonds are therefore a sell. The other group thinks the housing slowdown in the US will affect homeowners' perceptions of their own wealth and cause consumption to fall, hitting economic growth. They are natural buyers of Treasuries, as they see a slowdown draining inflationary pressures out of the economy.

The event that triggered the most recent Treasury market sell-off, therefore, wasn't anything to do with subprime, hedge funds, or even inflation fears (we know this because index-linked bonds didn't go up), but something else. As I said above, the Treasury market was lined up with two sets of investors facing off against each other. Then Goldman Sachs, UBS and Merrill Lynch, all of which had been calling for a cut in interest rates by the end of the year, changed sides to join the bond sellers. On the back of some good economic numbers for the US they pushed the forecast date of that first rate cut out to 2008. No wonder recent buyers rushed for the exits: if there isn't going to be a cut, there isn't much reason to own Treasuries right now. American ten-year bond yields had been in a downtrend ever since they peaked at 15.8% in September 1981. This latest bond sell-off has changed that.

That said, the US situation is still much like the UK's: despite recent rises, real yields are as low as they were in the 1990 recession or after the dotcom crash. There's lots of noise about the nominal Treasury yield breaking up through the 25-year downtrend (see chart 5), but still real US government bond yields are low too low. Again, instead of warning us about inflation, bond yields are telling us that a significant slowdown could be imminent. Sure, inflation might be out there, but the bigger risk is recession. The big banks that sparked this most recent sell-off aren't exactly calling for a rate rise they've just moved their timing on a rate cut out a quarter.

Is there a slowdown ahead?

So here's the question: is there a slowdown ahead? To answer this we need to look at the US subprime market. The first public victims of the subprime default rate rocketing recently in the US have been just two or three hedge funds. The sums involved have been big, but not excessive, and all concerned are pretending the damage is done. But we know defaults will continue to accelerate for some time. We also know that huge numbers of funds around the world are holding various derivative securities in some way backed by the subprime sector. Those securities are turning out to be far riskier than anyone thought possible and ratings agencies are now downgrading them. Worse still, many are very illiquid, so no one really knows what they're worth or the true size of potential losses to those who own them. It looks like a vicious cycle in the making.

Many say the subprime problems are too small in themselves to cause any real meltdown in the world's financial systems. I disagree. Subprime troubles have already caused a significant credit crunch at the low end of the housing market and made spreads widen at the riskier end of the credit market (ie, the difference between the rate for safe loans and the rate for risky loans is getting bigger). Credit crunches start at the risky end of the market, but tend to roll up the chain fast.

A year ago I warned that bond markets were a bad bet and that has proved to be the case. But what the bond markets are really telling us now is that a great many other things are a bad bet too. Bonds are worried about economic growth and high risk debt. When credit spreads balloon, as it looks like they now will, everything that relies on cheap loans to finance risky or illiquid assets such as private equity, property, junk bonds and emerging markets will be at risk. When highly leveraged investors in illiquid assets are forced to sell, the carnage can be brutal.

Even the yen carry trade is at risk of unwinding if the risky assets that players have been buying with their yen loans blow up. The yen surged over 43% against the US dollar in just 14 months in 1998-1999, when the Russian debt crisis and LTCM debacles last blew out credit spreads to 1,000 basis points or more. Do not believe it can't happen again. And if you are investing, stick to low p/e, safe, liquid, high yielding, mega-cap blue-chip stocks.

How interest rates move bonds

Most bonds carry a fixed coupon, say 4%, paid out at regular intervals over their life. If interest rates rise, the fixed payment, here £4 a year on a £100 bond, gets less attractive relative to what could be earned by putting money into a low-risk deposit account, so bond prices tend to fall. When interest rates rise or are expected to (as economic growth or inflation expectations rise, for example), bond yields rise and bond prices fall. Conversely, when interest rates are expected to fall (as investors expect economic growth or inflation to fall for example) yields fall and prices rise.

The bond funds to sell now

Over the last five years owning bond funds has been a fabulous way to make money. Invesco Perpetual Corporate Bond has returned 40.96%, Old Mutual Corporate Bond 38.49% and Aegon Sterling Corporate Bond 35.04%, according to data from Citywire. Over the past year, though, things haven't been so good. These funds have returned 0.7%, 0.1% and 1.6% respectively. Figures from Morningstar show that £1,000 invested in the average corporate bond fund a year ago would now be worth £991 and that of the 93 funds in the sector only 20 have managed to produce a positive return at all, with the Virgin Money Income fund and the HSBC Corporate Bond fund proving to be particularly dismal performers. The smart money has been selling up in a hurry: £674.9 million has left the sector since January.

Investors still holding funds might be wise to do the same. As Andrew Merricks says in What Investment, "with interest rates having risen again (and some seeing rates at 6% by the year end), why should anyone invest in bonds with a potential downside risk when you can earn more from cash with no risk to capital?" "We're as light in bonds as we can be, we just don't see the returns," says Andy Brunnerof Forsyth Partners on Reuters. That makes sense to us.

James Ferguson also runs his own share-tipping service, Model Investor.