Gilts come in from the cold

The Jonathan Davis Column

Jonathan Davis
Saturday 07 February 1998 00:02 GMT
Comments

Some more thoughts this week on the subject of equities versus gilts, prompted by the publication of Barclays Capital's annual gilts- equity survey. As regular readers will know, I have been promoting the attractions of gilts as a sensible home for investment capital for some time, and it is encouraging to find a lot of supportive arguments for this in the Barclays study.

What the survey shows in essence is that gilts, having been for years the pariahs of the investment community, are once more an attractive and sensible proposition for investors.

The main message of the Barclays study remains, as it has been since it was first launched in the mid 1950s, that equities are the best asset class for long-term investors. The data in the study goes back to 1918 and shows, if you are prepared to hold your portfolio of shares for 20 years, you are, in effect, immune from the risk of losing money.

Despite two world wars, Opec and all the rest of the 20th century's horrors, there has been no 20-year period this century during which you would not have shown a positive real return from holding a broadly based equity portfolio.

At a global level, the Barclays data supports the view that equities are superior long-term, but the margin of superiority is obviously not so clear-cut.

For example, its calculations show that if your transactions costs amount to just 1 per cent of your portfolio's value each year, it can cut the final value of your portfolio by 50 per cent over a long period. For a higher-rate taxpayer, the long-run real rate of return from shares falls from 6 to just over 4 per cent per annum.

Gilts are a rather different story. For most of the post-war period, they have been a disaster as an investment class. Inflation is the great enemy of all fixed-interest securities and,with the concomitant high level of interest rates, ruined the value of all types of gilts for many years. Anyone who bought gilts in the 1960s and reinvested the income would have seen the value of their investment roughly halve in real terms by the mid to late-1970s.

Since then, however, their performance has been steadily improving, helped by the worldwide assault on inflation by governments. Not only have total rates of return (income plus capital appreciation) been positive for a period of years, but since 1990, with the global fall in real interest rates, we have also had the almost unprecedented experience of seeing real increases in the capital value of gilts as well.

As the chart shows, the overall performance of gilts (after allowing for tax at the basic rate and for the effects of inflation) has been steadily upward since around 1980. It has not been quite as good as the performance of shares, but it has been way ahead of the performance of the typical building society account (which continues to lose value in real terms for savers who pay tax).

The conclusion of Michael Hughes, the economics adviser at Barclays Capital and the man responsible for its study, is that gilts are once again becoming a sound alternative to equities. Not only are economic fundamentals working in their favour but investors are also starting to benefit from a shift in the relative valuation of gilts versus equities. That is to say, while shares are highly valued by historical standards, gilts are not - not surprisingly, since memories of the bad experiences of the past are firmly etched in many investors' minds.

Of course, gilts will remain vulnerable to any sudden inflation shocks. If you think that such a shock is likely, then gilts are probably still not for you. But bear in mind that neither gilt yields nor risk-adjusted gilts returns have yet returned to the level they enjoyed before inflation sent them to the investment doghouse in the 1950s.

Given that equity valuations are so high, Barclays suggests the gilts renaissance is likely to continue for some time. They expect gilts to continue to provide positive real rates of return, and also for the yield ratio (the ratio between gilt yields and dividend yields) to continue falling. I am confident that their analysis is soundly based.

Of course, equities are riskier and more volatile than other types of asset. If you start buying when shares are highly valued (as they are now) you may have to wait longer to reap the rewards, and the returns you can expect will be lower than if you start out when valuations are low. In fact, the Barclays data suggests that when the market's dividend yield is as low as it is now (under 3.5 per cent), the real rate of return on equities you can expect over the next five years is, on average, going to be negative, though over 10 years it will still be marginally positive.

By contrast, when the stock market is yielding over 5 per cent, as it was in 1992, precedent suggests the likely five-year real return you can expect is nearly 10 per cent per annum.

The lesson from history is clear: long-term investors are generally well rewarded for taking on board the risks of share ownership. This is true even after you have taken into account the things which are often overlooked when investment companies use the Barclays data in their advertisements for equity-based savings products.

What these advertisements forget to mention is that the original data in the survey was prepared to convince pension funds and other investment institutions (who pay no tax) of the merits of equities over bonds. It takes no account of three things that can bear heavily on individual investors: the costs involved in reinvesting dividends every year, the impact of personal tax rates, and the charges levied by unit or investment trust management companies (assuming you don't invest directly yourself).

Join our commenting forum

Join thought-provoking conversations, follow other Independent readers and see their replies

Comments

Thank you for registering

Please refresh the page or navigate to another page on the site to be automatically logged inPlease refresh your browser to be logged in