Smart Investor: government bonds – how safe is a bubble?

It seems that commentators can agree on only one thing at the moment: nobody has the faintest idea whether the stock market will be up, down or at the same level in 12 months time.

Thus we observe an interesting schism in investment philosophy, with some investors betting on high inflation, choosing to buy what they believe are undervalued stocks. Other investors fear a deflationary period similar to Japan’s ‘lost decade’ of the 1990s, deciding to flock to the perceived safe haven of government bonds.

Sure, government bonds are safe (unless the country is called Greece, Spain, Portugal or Ireland of course) and you will receive a sum at redemption plus a coupon (interest) in the meantime. So far, so good.

Furthermore, the lost decade proponents may well turn out be right; we may experience a period of deflation and low interest rates, with continuing high national debts and budget deficits

The golden rule of investing

But even if they are right, are they missing the point by investing in bonds? Have they forgotten the golden rule of investing, a rule which has had to be re-learnt in the last few years? Namely, don’t lose the capital sum invested under any circumstances.

For example, a 10-year UK government bond currently yields 4.19% per annum, but costs a staggering £113 per £100 nominal. This means that upon redemption, purchasers will receive just £100 for every £113 invested, bringing the gross redemption yield down to a paltry 3.13% per annum due to losses made on the principal.

However, it seems this is a common approach to investing. In fact we see similar behaviour in stock purchasing, where the value of a company is simply not on an investor’s radar. Instead of deciding to buy shares as a result of thorough analysis of company accounts and reports, many investors choose to buy on forecasts, predictions or rumours.

A phoney safe haven

At the moment bonds are being bought simply because they are considered a safe haven and not because they offer long-term value, in terms of income and capital appreciation. Furthermore, bond prices and interest rates are joined at the hip and with interest rates at 0.5%, bond investors cannot reasonably expect to make a profit on the principal by selling before the redemption date.

So how can the smart investor guard against what could be a phoney safe haven?

A good start may be to remind oneself that the economic cycle has not been a victim of the credit crunch; it is still very much in existence, with bonds being most attractively priced when interest rates are at their highest. Thus the time to invest in bonds has passed because gross redemption yields and interest rates are simply too low for bonds to be an attractive proposition in the long run.

Look for value

Of course debate will rage over the future direction of shares, but this should be of little concern to the intelligent investor, for he will simply pick up shares in companies that he believes are undervalued. If share prices fall, more opportunities will present themselves. If they go up, he will profit from the ones he previously identified.

As for inflation, if it remains high history tells us that stocks are not a bad place to be. If we experience deflation and a lost decade, stocks bought at a fair price and that pay reasonable dividends may prove to be the elusive silver bullet.