Personal Finance: At a time of economic downturn, bonds might offer the best bet

Brian Tora

NO, I WASN'T on holiday last week. When markets move with the speed and perversity that we have seen recently, there are times when it is just too difficult to escape the attentions of the trading screen.

It is the likely direction of interest rates that presently motivates markets. Not long ago, we were anticipating a further rise in the cost of money as the Bank of England's Monetary Policy Committee attempted to head-off inflationary pressures. Now the market is factoring in a rate cut - probably by the end of the year - to compensate for the turmoil wrought by the emerging markets' crisis. A rate cut is also expected in the US.

There was an interesting comment in a recent market report. It referred to equity prices falling as a consequence of renewed strength in bonds. This does not sound like the usual received wisdom for markets. Normally, buoyant gilts encourage equity buying. Today they seem to be moving in different directions. Look at a chart of the reverse yield gap. It has fallen through the floor.

The attraction of bonds has been helped by the flight to quality given the turbulence in the markets of the Far East, Latin America and eastern Europe. But there is a fundamental reason for buying bonds as well.

If developed countries are to head-off a world recession, interest rates must come down, it is argued. In the US, a budgetary surplus is in prospect, so fewer bond issues are likely. Anyway, inflation is not a problem there. Indeed, another argument suggests that inflation is overstated in the developed world, particularly in the UK. If this is indeed the case, then interest rates are too high and bond yields might be expected to fall further.

What happens if action on interest rates is insufficient to prevent collateral damage to North American and European economies in the wake of disruption elsewhere? You only have to look at Japan to see what might happen. Consumers aren't spending and savers are simply hoarding. In circumstances like these, it is all too easy to imagine prolonged periods when bonds and equities travel in different directions.

So the argument against bonds seems to rest with optimists who believe we will manage to stave off a recession in the West. Our little oasis of prosperity may not have much longer to run, though: companies are already delivering profit warnings and there seems little doubt that economic activity is now being hit.

If you do feel you have missed the boat in bonds, then there are plenty of alternatives giving higher returns, which may be valuable in a deflationary environment. Zero dividend preference stocks, for example, now yield fully 2 per cent more than gilts, whilst there are plenty of corporate bonds around giving attractive returns. I am an optimist by inclination, but think we are heading for a sharper economic downturn than markets are suggesting. In bonds I may have found that home for my pension fund money after all.

Brian Tora is chairman of the Greig Middleton strategy committee