Bonds Away! (Portfolio Sale)

Here's the thing (as they say in those American films): why have the prices of many UK fixed-income securities continued to increase recently?

 

To recall the basics truisms: the yields on all securities are related, with yields on low-risk government bonds setting the baseline; interest rates on cash deposits also influence yields in the market; the 'value' of fixed-return yield is also undermined by the level of inflation.

 

So, looking into the crystal ball, what is likely to happen to a) interest rates and b) government bond prices and c) inflation?

My financial world is build around yield - the ratio of price divided by annual income (historic and forecast). For fixed-income securities (and to a degree, dividend shares), yields change inversely with the price - and the price is a result of market action. Yield is also an indicator of market interest - with a relatively high yield meaning that the market is wary of a security for a particular reason: high yield = high risk.

So, having said that, what kind of future does the market hold for fixed-income securities? As outlined above, it seems to me that  the three main (linked) factors for the near future, likely to have a profound impact on market yield levels are:

• the unwinding of Quantitative Easing (QE in the UK, US and elsewhere, which means that the central banks stop buying government stock (bonds), resulting in a fall in their price - and thereby an increase in the yield
• increases in the  'repo' central bank rate of interest (the bank 'base rate'), resulting in a rise in the general rate of interest on cash deposits
• increase in inflation, or at least a sustained level of inflation at the level of 2-3%

And the prognosis for the price of fixed-income securities, such as bonds, PIBS and preference shares? The only way is down. This is not a particularly original thought - the Great Rotation, from bonds to shares, has been talked about for years. But it just hasn't happened in the UK, where I do most of my investing (it may have happened in the US).

Look at this chart from Hargreaves Landsdown for the Principality Building Society 7% PIBS (PPR7). What is the logic? OK, in early 2012, there may have been concerns about the sustainability of some of the PIBS. But how do we explain the recent remorseless rise towards (and beyond) par.

But is this a one-off? I don't think so - have a look at the chart (from Digital Look) for Aviva's 8 3/4% Cumulative Irredeemable Preference Share (AV.A) - a similar picture (even including the hiccup in mid-2013).

So, for a DIY Income Investor, what is the indicated course of action? I've decided that I don't really understand what is going on, so I'm getting out and taking profits.

My first sale is my holding of PPR7 (see above), bought two years ago and netting a 31% profit of several thousand pounds.

This is a major strategic move in the portfolio and will result in a much higher proportion of dividend shares than the 50% I was previously targeting. Hopefully the yield landscape will adjust back to normal in a couple of years and I can balance up again to 50/50.

[Sale price: £0.9825]


I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.