Six months is a long time in markets. Since I last wrote about the levels of income obtainable in the bond market, options have become even fewer and more challenging as prices of bonds have risen, in some cases substantially. Yields have contracted since April. Surprisingly though, not yields in Malta.

Pockets of the bond market still have legs to run further- David Curmi

According to BCA research, since September 1981 the total real return from US Treasuries has averaged almost nine per cent per annum. Over the last decade it has been almost double that at 16 per cent per annum.

European bond markets have also performed extremely well, with 10-year German Bund yields falling from nine per cent in 1991 to 1.4 per cent today. The Open Market Transactions strategy by the ECB and the announcement of QE 3 by the Fed is the latest reason why bond prices have continued to rise. Investors believe that the risk in the euro area is now much reduced following the ECB’s actions.

With yields now so low, is it wise to continue investing in bonds from this point forward?

The story for not buying bonds at the moment goes like this: income from bonds is so low it is almost negative after taking inflation into account. Inflation expectations are starting to spike upwards – in the US forward looking inflation expectations are now at 2.8 per cent.

This is almost double the yield on 10-year US Treasuries. When bond prices start to factor in some inflation, or even the possibility of it, capital will quickly start to erode and it could be a fast slope downwards. Meanwhile, dividends are at record highs while dividend payouts are at record lows in the US. And, according to S&P this year, a record number of companies will be paying dividends.

All this is fine but it presupposes, however, that we will shortly be out of the present economic challenges and economies will start to grow again. Reality could be quite different.

Economies are still spluttering and growth has not shown any real traction.

A Japanese-style outcome is still a possibility. The risk is inflation. Economic theory suggests that the action taken by the Fed and the ECB will, at some point, filter through into inflation figures but there is little evidence of this just yet and, with unemployment remaining stubbornly high, and with limited wage pressure the genie is not yet out of the bottle.

I suspect that Central Banks are not going to throw away 20 years of effort to control inflation that easily. If inflation does rear its head at an uncomfortable level I am convinced Central Banks will act. But the risks now are such that investors need to look at what is being priced in to the market and react accordingly. Following a very strong September rally, corporate credit has capped an impressive nine-month period. Where to from here?

Pockets of the bond market still have legs to run further but energy levels are running low and investors need to think about repositioning themselves once again.

The move downwards in yields makes it difficult to continue justifying taking further risks.

Alternative strategies need to be developed. More weight therefore should be given to dividend streams from very high quality companies. It is today quite common to find that dividend yields on many quality corporates are higher than the interest coupon on bonds by the same issuer.

This is itself telling a story. Dividends offer an element of inflation protection if the dividend policy and the performance of the company are such that a progressive dividend is possible.

The use of equities as part of a portfolio needs to be a carefully structured strategy but if this is possible there are some excellent dividend paying stocks that can be picked up.

And over the longer term, I am convinced that the performance of this type of equity will be superior to its equivalent in the bond market.

Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the author’s objective and independent opinion. It is based on public information and should not be viewed as investment advice in any manner. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Mr Curmi is managing director of Curmi and Partners Ltd.