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Ian Cowie: Brexit anniversary brings bad tidings for bonds

Ian Cowie: Brexit anniversary brings bad tidings for bonds

Will Brexit mean the busting of the bond bubble and the end of a multi-decade bull run in gilt-edged stock? Will fixed interest securities be among the first casualties of Britain’s freedom from the European Union?

Next week will mark the first anniversary of the Brexit referendum and the beginning of talks about what this momentous decision will mean in practice. But investors interested in its financial consequences need not wait.

This week’s spike in the annual rate of inflation – as measured by the consumer prices index (CPI) – gives a foretaste of what is to come as the incredible shrinking pound pushes up the price of imported goods and services. CPI hit a four-year high of 2.9% in May, compared to 2.7% one month before and just 0.2% in October, 2015. Go on, you join the dots.

There’s no need to take my word for this. Here’s what Dame DeAnne Julius, a founding member of the Bank of England’s monetary policy committee, told The Times’ annual CEO Summit: ‘Inflation is awakening from its decade-long sleep and near death descent into the negative underworld.’

Who says bonds are boring? Pension funds stuffed with gilts at the behest of government-appointed regulators are about to discover just how exciting these bonds can be when real rates exceed the nominal yields they purport to offer – and investors ask why they should buy any more return-free risk?

For the benefit of the hard-of-thinking, the Dame explained: ‘The global credit crisis took a long time to unwind and this has kept inflation low. The world economy is now in the early stages of a cyclical upswing. Higher inflation and rising interest rates should be celebrated as the by-product of a healthy recovery.’

Bondholders who bought in when redemption yields were nugatory – or, worse, guaranteed real losses – are unlikely to be among those celebrating when fixed interest capital values are revised downward. But investment trust shareholders – who have been largely spared the bond mania of many open-ended funds – are already enjoying the rewards of accepting the risk inherent in equities and other variable return assets.

This is most obviously expressed in many trusts’ share prices hitting all-time highs and their discounts to net asset value (NAV) trading near all-time lows but, for the new generation of pension freedom investors, the effect on the income they receive may prove even more important.

James Henderson, fund manager of the Lowland Investment Company (LWI), points out that £10,000 invested in a broad basket of equities in 1997 currently yields about £704 a year. Bond buyers back then could have beaten that with an initial yield of about £750 but would get only £150 today. It was a similar story for risk-averse depositors; they could have had annual income of £138 per £10,000 deposited two decades ago but a meagre £22 today.

Never mind the past, though, what about the future? Henderson explained: ‘This means equity yields can provide real income. As company profits and the economy grow, so do dividends whereas bond interest does not.

‘Equity income is somewhat protected from inflation and represents a genuine growth opportunity as business revenue and earnings should increase around the same pace as inflation, which means the prices of shares should rise along with general prices of consumer and producer goods.’

This would have scarcely needed explaining three decades ago but the long intervening period of falling interest rates, rising bond yields and – most recently – financial repression, is coming to an end.

A new generation of bondholders and bank depositors is about to discover the meaning of ‘reckless prudence’, which was a commonplace phrase when I began work in the City more than 30 years ago.

More positively, investment trust shareholders and others exposed to equities will benefit from rising inflation and interest rates. Brexit means winners and losers but, most of all, it is bad news for bonds.

Full disclosure: here is a complete list of Ian Cowie’s stock market investments. It is not financial advice nor is any recommendation implied.

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