Why bonds may not be the safe haven they once were

If you want to cut the risk in your portfolio, what should you do? Look at the recent discussion over how defined benefit (DB) pension schemes should be funded, and you’ll get a good sense of the group-think on the topic. As far as most people – and the UK government – are concerned, if you want to “de-risk” so as to be sure of meeting your long-term pension obligations, you have to shift into bonds, and in the UK, into gilts. That made sense when you could expect bond returns to be positive in nominal and inflation-adjusted terms. It explains why around 70% of private DB assets are in long-term bonds, and why 75% of those are gilts. It also explains why individuals near retirement are encouraged to shift from the standard portfolio mix of 60% equities and 40% bonds, to more like 100% bonds.

But does it really make sense now, or has the long-term shift in bond yields from something to nothing over the last 30-odd years changed the relative risk profiles of asset classes? Is de-risking into gilts really pretty risky? That would certainly be true if inflation takes off into 2022 (see page 4, and note that Joe Biden’s stimulus plan is likely to be huge) and if interest rates lagged inflation as that happened (which they will – governments hold too much debt to allow government bond yields to pop higher). Who would want to hold assets guaranteed to lose at least a couple of percentage points of real value a year? And who would hold them as part of a low-risk strategy? It might work for the government for us all to think that bonds are low risk (they have a lot to sell) but it’s hard to argue that, barring a whopping new deflationary recession, it works very well for the rest of us.

Yet stating that bonds aren’t much of a safe haven isn’t much use if you can’t name another (beyond gold!). Our answer is much as it usually is: we should perhaps define long-term safe havens less in terms of historic norms and more in terms of actual value – or in these days of everything being over-priced, relative value. I’m quite taken with the idea that tech stocks have become something of a Covid-19-era recession hedge: if anything goes wrong and we end up back at Covid-19 square one, it will be America’s big tech stocks that win again. But it is too much for us to define any sector on record-high valuations as in any way safe (the US is on a cyclically-adjusted price/earnings (p/e) ratio of well over 30).

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That brings us back to the UK. In the relentless negativity of the last few years. It’s easy to forget that we got a perfectly reasonable Brexit deal through in a year (please don’t write to us about the teething problems until it is clear that they are more than that) and are in the middle of rolling out a pretty good (by global standards) vaccine programme that will hopefully return us to our old normal in the next few months.

Our markets are also getting more whizzy: the FTSE 100, long one of the world’s dullest markets, is about to get a sprinkling of tech fairy dust and as Jonathan Compton notes in this week's issue, we are no slouches in the booze and fizzy drink department either (I accept not everyone thinks this is a good thing). Finally, of all the main markets, it is probably the least overpriced relative to history. It is very far from perfect (a forward p/e of 15 vs a 15-year median of 12, says Duncan Lamont of Schroders). But right now, if you are looking to invest in the UK, it’s probably a better long-term bet than the bond markets – or cash for that matter.