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Base Rates and Yields

Adam Lawrence, Property entrepreneur and co-founder of Partners in Property, comments

There’s a danger with a subject matter like this that it can be very dry, technical and boring. Some of that is because there is an element of tedium in explaining mathematical relationships, and especially in the abstract. What I want to achieve in this article is to make this relatable - so to explain what I need to in the underlying relationship between base rates and bond yields - and then crucially, to explain why it all matters to property investors, who tend to have a long-term outlook.

Firstly, an insight into the world of the larger, more institutional investor. Why do they exist first of all - i.e. are they a sovereign wealth fund, investing for the future good of their people - and capital protection is important, but they are as yet without obligation to make regular payments, or are they a pension fund or an insurance fund - one (the pension fund) with a very good idea about the size of payments it will need to make, although there will always be variations in life expectancy), and the other with a very decent idea about the claims it will need to pay out and the
premia it might take in, but with a larger element of uncertainty.

What is their investment philosophy - well, to make good on their obligations, and to firstly protect capital as their primary methodology, and then to get positive returns on that capital and ensure the longer-term viability of the fund. One of my favourite phrases - return of investment before return on investment.

They might well, as part of their portfolios, invest in venture capital or private equity funds - many of which are willing to throw 100 darts to get between 2 and 10 winners, and to throw 1000 darts in the hope of getting one unicorn - the start-up valued in the billions of dollars in relatively short order. These types of investments will form a small percentage of what they do however - what they want is regular income, from a source that will not dry up - and that source is deemed to be government-issued bonds, that are the least likely to default/go bankrupt.

It is easy to wonder - who buys government bonds yielding 2% per annum (the current 10-year bond yield, roughly) when inflation is 9.4% (latest figure released)? Surely, they are losing 7.5% per year? Well, that’s not quite right. Inflation is looking backwards - not forwards - so the more pertinent rate is the best estimate for the forward rate, often called the breakeven. This is measured by looking at the difference between inflation-linked securities (in the US they call them TIPS - treasury inflation-protected securities, in the UK we call them index-linked gilts) and nominal yields - if the 5 year bond money is trading around 2% (a little under) per annum, then if there is a 4% gap between the nominal bonds and the index-linked gilts, we would read into that that the market expects the inflation rate over the next 5 years to average out at 4% (4% would be a high reading, the breakevens were near 4% last year but are closer to 3% this year, somewhat vindicated by the high inflation between last year and this year of course).

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