LONDON -- In 1956 George Ross-Goobey, the manager of the Imperial Tobacco pension fund, persuaded the scheme's trustees to switch most of its holding of British government fixed-interest gilts -- high-grade government bonds -- that were paying 3% into shares that yielded 4%.
This meant that not only did the fund obtain a higher income, but it also got some protection against inflation. The difference between the income paid by gilts and shares -- the "yield gap" -- had been justified on the grounds that shares were riskier investments; by the early 1960s, gilts yielded more than shares, a situation which became known as the "reverse-yield gap."
The yield gap has reappeared during the last few years, thanks to the recession and investors' fears that things will become a lot worse. So while the gross redemption yield on 15-year gilts is just under 2.4%, an index-tracker fund like the HSBC FTSE 100 (LSE: HUKX.L ) currently pays 3.6%. That's 50% more than on 15-year gilts, and it comes net of basic-rate tax, but it isn't guaranteed.
Why are gilt yields low?
The yield on long-dated gilts has fallen because of several factors, including the Bank of England's response to the recession and the credit crunch. By slashing interest rates, the Bank increased the attractiveness of gilts, while most of the money that it has pumped into the banking system through quantitative easing has gone into gilts, which has further depressed yields.
Many investors reacted to the world's economic problems by switching their money out of riskier assets and moving into gilts. The flight of money from less financially stable countries into the government bonds of the more stable economies such as America, Britain, Canada, and Germany has further driven down gilt yields.
In Britain, the demand for gilts has also risen because final salary pension funds are forced to increase their level of investment in fixed-interest bonds when gilt yields fall. Most other European countries have similar laws, which, to the cynical-minded like me, have always looked a lot like a way for the state to force domestic institutions to buy its debt.
We'll pay you to look after our money
The economic problems of some eurozone countries are so bad that many investors who need to hold euro-denominated debt have turned to the most secure form: the short-term bonds issued by the German federal government.
The demand for German debt has been so strong that a recent issue of two-year "bunds," which paid no interest, was snapped up. Negative interest rates, where investors are guaranteed to get back less than they put in, have been recently seen in the German bond market.
Investors buy these zero-interest bonds because, to them, the return of their capital is much more important than the return paid upon their capital. They don't want to risk the chance that they'll wake up one day to find out that the government whose bonds they hold has partially defaulted upon them and/or has exited the euro so that their bonds have been redenominated in a less valuable replacement currency.
Bond issuers love inflation
Milton Friedman showed us that inflation is primarily a monetary phenomenon caused by governments printing money. Inflation is an insidious tax upon the value of assets, especially cash and fixed-interest investments, though it is popular among debtors because it reduces the real value of their debts.
With Britain's national debt now approaching 80% of the GDP -- and a lot more once off-the-balance-sheet stuff is included -- it will be very tempting for future governments to let inflation rip. Though, since inflation has reduced the purchasing power of 1 pound in 1960 to about 6 pence today, this seems to have been official policy for most of the last 50-odd years!
Investors who kept their money in real assets such as gold, property, shares, and inflation-linked bonds, which can keep pace with inflation, have done much better over the last 50 years than those who kept their money in cash or fixed-interest bonds.
One consequence is that nowadays, many countries' bonds, rather than offering a risk-free return to investors, appear to give what James Grant, publisher of Grant's Interest Rate Observer, calls "return-free risk."
Think of the long term
Since the 1950s, history tells us that whenever shares have yielded much more than bonds, this is a strong signal to buy shares if you are prepared to take a long-term view and can ride out any further price falls as the yield gap invariably appears during an economic crisis.
History also tells us that buying bonds at very low yields is a good way to lose money over the long term. You can see this in the most recent Barclays Capital Equity-Gilt study, which shows that investors who bought American Treasury bonds paying 2% just after the end of the Second World War earned a real annual return over the next 35 years of -2.3%.
Plenty of good dividends
Lots of companies in the FTSE 100 pay more than the 3.6% yield paid by a typical index tracker. Two of the more popular among investors are oil super-majors BP and Royal Dutch Shell, whose shares pay dividends of 4.6% and 4.9%, respectively.
Some companies pay higher dividends, in particular utilities like National Grid (LSE: NG.L ) , whose shares yield 5.5%. Many investors view utility company shares as a hybrid of index-linked bonds and conventional shares, as their regulated monopoly allows them to impose price rises upon customers who have no alternative but to pay up. So their cashflows should be much more predictable, and their dividends should grow steadily over time.
But the utilities' dividends aren't guaranteed, unlike the returns paid by gilts, and they are exposed to the sometimes capricious behavior of regulators and populist, utility-bashing politicians. The example of the privatized phone companies around the world, whose monopolies have been eroded by the rise of the mobile phone, is something else to bear in mind.
Two utilities with local monopolies and businesses that are exceptionally resistant to technological change are the electric company SSE, with its 5.8% dividend, and the water company United Utilities, which yields 4.7%.
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