Why U.K. Bonds Are for Losers

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LONDON -- There are many reasons you may decide to buy a share, bond, or other asset.

You may buy an asset because it offers an attractive income yield, for the prospect of long-term capital gains, or because it gives you voting rights.

Alternatively, you may buy as a speculator, hoping only that you will be able to sell at a higher price to the next buyer. This next owner is known as the "greater fool" (note the small "f"), and he often disappears just when he is most needed.


The bond bubble
You also may decide to buy an asset purely because it is a sure and safe haven in troubled times. At the moment, this is what's happening with highly rated government bonds, notably U.K. gilts, German bunds. and U.S. Treasuries.

Indeed, "risk off" buying of U.K. gilts has pushed up their prices to all-time highs. As a result, gilt yields have dropped to their lowest levels since the Bank of England's records began in 1703. That's right: Buying gilts today means earning the lowest coupons in at least 309 years.

As I write, the yield on the 10-year gilt has dropped to 1.86% a year, which is absolutely the lowest fixed income ever paid by these benchmark U.K. bonds.

This is great news for HM Treasury, as ultra-low gilt yields sharply reduce the interest bill the U.K. must pay on its 1 trillion pounds of national debt. However, such low yields spell future disaster for bondholders when interest rates start to rise and cause bond prices to plunge.

Safety versus income
Of course, the main attractions of gilts are that they offer both liquidity (ease of buying and selling) and safety to shell-shocked investors. This is because they are backed by "the full faith and credit" of the British government.

Indeed, during a rush to safe havens prompted by the ongoing eurozone crisis, 10-year gilt prices have risen almost a sixth (nearly 16%) in the past 12 months.

However, because bond coupons (their regular income) are fixed, bond prices take a knock when inflation is high or rising, when interest rates rise, or when an issuer's credit rating is downgraded. Given that all three events are likely to happen in the U.K. in the coming decade, gilts look to be a medium-term catastrophe, it seems to me.

Why buy gilts?
As a private investor, I'm not a pension fund, insurance company, or major bank. Therefore, there is no regulatory obligation on me to keep a substantial slice of my free capital in highly liquid -- but also highly overpriced -- government bonds.

Thus, instead of being sucked into the gilt game and ending up a loser, I'd much prefer to stack the odds in my favor and emerge a winner. To do this, I would buy a selection of blue-chip, megacap shares that offer an overwhelming income advantage over gilts in the form of high, well-covered dividend yields.

Six dividend Goliaths
For example, here's a mini-portfolio of six FTSE 100 businesses that all pay chunky cash dividends to their shareholders (sorted by dividend yield):

Company

Share Price (Pence)

Earnings Rating

Dividend Yield (%)

Dividend Cover

Aviva (NYS: AV) 270.24.98.92.1
AstraZeneca (NYS: AZN) 2,634.507.16.62.1
Vodafone (NYS: VOD) 164.910.65.31.9
J Sainsbury296.110.35.21.8
GlaxoSmithKline (NYS: GSK) 1,422.5011.65.21.6
Royal Dutch Shell (NYS: RDS.B) 2,045.507.25.12.7

Source: Digital Look.

These household names pay dividends ranging from 5.1% at oil giant Royal Dutch Shell to 8.9% at insurer Aviva. Overall, the average dividend yield for this concentrated portfolio exceeds 6% a year.

In my view, and based on current yields, only fools and institutions would buy gilts right now. Any sensible investor seeking a high and rising income -- plus the possibility of capital growth -- should be switching into lowly rated FTSE 100 stocks.

In summary, why be a guaranteed loser over the next decade by buying gilts and similar low-yielding bonds? Instead, emerge a winner by banking a generous income from dividends while waiting for the world economy to right itself!

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At the time this article was published Cliff D'Arcy owns shares in GlaxoSmithKline.Motley Fool newsletter serviceshave recommended buying shares of Vodafone Group and GlaxoSmithKline. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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