Do Brexit fears make bonds a better buy than the Footsie?

In the last two months, bond yields have risen dramatically. A 10-year UK government bond (gilt) now yields 1.1%, while back in August it yielded just 0.5%. This may mean that many investors are considering the purchase of bonds, since their income return is improved. However, is this a good idea? And should investors sell their shares to do so?

Clearly, holding some bonds within a portfolio is generally a good idea. They have much lower risk profiles than shares since a lender ranks higher in case of default than an equity holder. They also help to diversify a portfolio and offer a counterweight to falling share prices if market uncertainty increases.

Furthermore, bond prices tend to move in the opposite direction to interest rate changes. For example, in a falling interest rate environment bond prices usually rise to offer lower yields. With the Bank of England adopting a dovish policy and likely to reduce interest rates before it increases them, bond yields could fall and bond prices may rise. This could lead to capital gains for bondholders.

However, the reality is that bond yields could also move higher as a consequence of Brexit. That’s because confidence in the UK economy is now lower than it was before the EU referendum. Therefore, investors may view the UK government as a less secure borrower and government bond prices may fall. This could lead to capital losses for bond holders, since confidence in the UK economy may fall as negotiations surrounding Brexit begin to take place in 2017.

UK uncertainty

Of course, UK-focused shares also offer a rather uncertain outlook. UK GDP growth is forecast to be exceptionally low in 2017 and unemployment is expected to rise. This could lead to difficult trading conditions for UK-focused companies. As such, some shares could fall over the medium term. However, in many cases they offer a wide margin of safety and so the problems associated with Brexit may already be priced in. Therefore, their performance over the medium term may be relatively strong.

One impact thus far of inflation has been a weaker pound. This has caused inflation to increase to 1% and further rises are likely. The Bank of England has stated that inflation could surpass 3% over the coming years and it may be forced to retain a low interest rate to support economic growth. In this situation, the return on bonds could be negative in real terms. By contrast, the FTSE 100 yields around 3.6% and also has capital growth potential. Therefore, shares could be a better means of maintaining and even growing purchasing power over the medium term.

Beyond holding bonds as part of a diversified portfolio, there seems to be little reason to sell shares in order to buy them. Yields of 1.1% are still historically low, while a FTSE 100 yield of 3.6% is relatively high. As such, buying shares rather than bonds seems to be the best move at the present time.

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