The latest fund sales statistics from the Investment Management Association, released last week, showed equities favoured over bonds for the first time in 12 months. Leading asset allocators have suggested for some time that bonds of all types are overvalued and investors should be rethinking their preference for the sector.

This is the first suggestion investors are now re-examining their bond exposure – but is it too little too late?

At first sight, the case against bonds looks reasonably clear-cut. Gilt yields are at the end of a multi-decade contraction. It is plausible a combination of risk aversion and further quantitative easing will push them lower, but the risks all look to be on the downside – particularly if, as some experts predict, the UK’s credit rating falls. The process may already have started and gilt yields have backed up over the past three months.

Corporate bonds are the top-performing asset class over six months and corporate bond fund managers argue investors are still being relatively well-compensated for taking the additional risk of corporates over governments. But net issuance is poor, liquidity a struggle and groups such as Nestlé and BP are able to borrow in the capital markets at below 2%. Equally, corporate bonds – particularly at the high-quality end – are vulnerable to any fall in gilt yields.

That said, the average corporate bond fund still has a historic yield of between 3.5% and 5%. In a climate of near-zero interest rates, this still looks like a reasonable income for relatively little additional risk. This, presumably, is the calculation investors are making and why they are not shipping out of fixed income wholesale. However, they may start to recalculate as those yields fall further.

The strategic bond sector continues to be popular as many investors look at bond markets, conclude it is too difficult to analyse and aim to pass the buck to professional bond managers. But there are inherent dangers in this approach as well. All bond markets have performed well and look highly valued so just because a bond fund manager can allocate between one overvalued market and another may not save investors from weakening returns.

What will be the catalyst for the bond market to roll over? There is nothing imminent, which may be why bond investors have managed to cling on so long. There appears no immediate danger of a hike in interest rates, a surge in inflation or a return to punchy growth, any of which would derail the bond market speedily. However, as investors are starting to realise, the upside in the bond market is waning and the downside may be severe.

November 2012