Walking the line

We discover three excellent bond funds and suggests a few good reasons for maintaining a decent-sized bond holding

The Gen on the world’s bond markets is that they have all-but run out of steam. The popular argument has it that central banks’ have trimmed interest rates as low as they dare. The only way for base rates now is up, say analysts, economists and various other experts. Bonds, therefore, are about to take a deep bath. Equities, this argument goes, are due a rally in 2002. This is supported by the fact that yields on 10 year US treasury bonds have risen by 80 basis points since their lows because investors confidently expect to see better returns from other asset classes.

So if bond yields are likely to rise further (thus diminishing capital values) then the question is whether canny investors should be seeking to off-load bonds and concentrate instead on cash and equities? Well, the answer, sadly, is not as straightforward as the question. For diversification and income alone, bond holdings remain an integral part of many investors’ portfolios.

More importantly, risks engulfing the global markets remain significant and any massacre of bonds may never really materialise. For starters, many analysts have voiced concerns that last year’s (fourth quarter, principally November) equity rallies were based upon two things: post-September 11 opportunism, and a sea of liquidity that was poured into the global finance system by central banks going straight to some debt-mired companies’ bottom lines.

The problem, as we go to press, is that there has only really been anecdotal evidence that companies’ earnings have risen as expected. Indeed, Dr Alan Greenspan of the US Federal Reserve has warned that corporate America is not certain to recover this year. And if equities do fail to rise in line with expectations, then bonds could be attractive for a while yet.
Unconvinced by this reasoning? You think that the vast consumer spending in shops will improve earnings and therefore make certain sorts of equities rock solid opportunities (to the detriment of bonds)? Well there is plenty of support for a positive view of equities.

But let’s continue with this gloomy theme a while longer. Suppose there was a significant negative economic event in 2002. Imagine, for argument’s sake, that Japan sinks further into a deflationary/recessionary/depressionary/debt-sodden quagmire that panics other central banks and makes them believe they need to cut their interest rates even more to avoid similar deflationary difficulties. Suppose, just to be horribly pessimistic, that speculators start betting serious money that Japan will default on her sovereign debts. (Incidentally, The Lex Column in the Financial Times Newspaper (January 5-6) said Japan was moving “inexorably” towards a default.) Or look at it another way, suppose retailers simply fail to earn as much over Christmas as the markets seem to expect.

Perhaps all the above is unduly negative. The fact is that many analysts are optimistic about equities in 2002. Japan could impose reforms that bolster the investment community’s confidence. Consumer spending could boost companies’ earnings and - coupled with cost reductions from cheaper debt – make their results look very attractive.
Nevertheless, nobody knows for sure which way the world’s markets will swing and the argument for a diverse portfolio of assets still holds. Risks remain, and, in such circumstances, owning a few bonds makes sense.