Low inflation calls for some bonding

The 1980s was the decade of the equity. For years, the number of shares in private hands had been declining until the Thatcher government swept in with its privatisation policy and the encouragement of wider share ownership. Sid and thousands of his colleagues followed the call.

The incentive to hold bonds, meanwhile, was relatively small, and to hold cash it was smaller still. The returns on equities easily outshone those on other forms of investment. Now, however, that is changing. It is time for Sid to consider whether he would be better off switching some of his shareholdings.

Equities inevitably do well in inflationary times because dividends generally rise in step with prices and the underlying asset value of companies also rises. Government gilt-edged bonds, on the other hand, do relatively badly because (except for indexed-linked gilts) their return is fixed and there is no underlying asset value.

But when inflation is low, the reverse is true - bonds suddenly start to look very attractive. That is the stage Britain and other leading western economies have reached.

"The forces acting on the world economy to keep inflation down did not exist five years ago," says Ian Douglas, director of bond market strategy at UBS. Factors such as the opening up of the huge Chinese labour market and the consensus in the West to keep inflation low at the expense of higher economic growth have been crucial.

"Inflation of only 3 per cent is probably too high an estimate for Britain over the next few years," says Robin Aspinall, economist at Panmure Gordon. To bring bond yields - their price in relation to the interest rate they pay - into line with this level of inflation, bond prices will have to rise substantially.

The canny investor will therefore put a higher proportion of bonds into his portfolio. In the 1980s, it was typical for professionally managed funds to hold only 20 per cent in bonds and the rest in equities - while many private investors held no bonds at all. "Over the medium term, investors should go towards about 40 per cent in bonds and only 60 per cent in equities," Mr Douglas said.

And this year may be an excellent time to buy them. Bond yields are now very high, which means their price is low. On 10-year gilts, for example, the real yield (above inflation) is around 4.5 to 5 per cent compared with a historically normal level of around 2.5 per cent. In other words, yields are probably unsustainably high at the moment, which means that gilts are dead cheap.

This is partly because of the bond market collapse last year, which scared many investors away from the market. It is so because many professional investors are still in their 1980s equities mind-set and have not yet woken up to the potential for bonds. They still cannot believe that inflation is being conquered.

"The markets are too pessimistic about inflation and interest rates," says Tim Congdon, economist at Gerrard & National. Over the next few months there is likely to be a tic up in inflation and a consequent rise in interest rates. That will temporarily hold down bond prices, perhaps until the end of this year. But the cycle of interest-rate rises is already nearly complete. "We've already had the bulk of the interest-rate rises and the economy is beginning to weaken," Mr Congdon says. Once interest rates and inflation start to fall again, bonds are bound to do well.

The same cycles are taking place in Germany and the US, two other key government bond markets. For UK investors, Germany is probably a better bet because an exposure to German marks looks safer than one in dollars.

Government bonds, however, are not the only type worth looking at. The UK corporate bond market has always been a tricky area for private investors, partly because they are rarely easy to buy or sell. "I'm not keen on them," says Geoffrey Pointon, chairman of Pointon York, the investment advisers. "Historically, their performance against gilts or equities is dire."

One exception are the Permanent Interest Bearing Shares (Pibs) issued by some building societies. They are more secure than the bonds of many industrial companies and their yield is substantially higher than comparable gilts. A typical Pibs now yields around 10 per cent (without accounting for inflation), while an undated gilt yields about 8.25 per cent.

National Savings, the government savings department, also issues bonds for private investors, but unlike gilts and other bonds, the capital value does not fluctuate. In this sense, they are closer to long-term deposits than to ordinary bonds. Nevertheless, their rate of interest is set to correspond with what the Government is paying in the gilts market, although the rate will be slightly lower. The five-year, tax-free Savings Certificate, for example, currently pays 5.85 per cent. If that rises further in line with interest rates later in the year, higher rate taxpayers in particular will be able to lock themselves into an extremely attractive and risk- free rate of return over the medium term.

In a world of low inflation and low interest rates, simply holding cash on deposit will remain as bad as it always has been as a medium to long term investment. Building societies currently offer between 3.5 and 7.5 per cent, which is taxable..

Their rates may look fairly attractive for the rest of this year, but once other interest rates start to fall again there will be little incentive to hold much money in cash. A foray into the bond market could, for the first time in many years, prove the most profitable choice.

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Recruitment Genius: Customer Service Advisor

    £15000 - £16000 per annum: Recruitment Genius: A Customer Service Advisor is r...

    Ashdown Group: Trainee Consultant - Surrey / South West London

    £22000 per annum + pension,bonus,career progression: Ashdown Group: An establi...

    SThree: HR Benefits Manager

    £40000 - £50000 per annum + pro rata: SThree: SThree Group have been well esta...

    Recruitment Genius: Office Manager / Financial Services

    £30000 - £37000 per annum: Recruitment Genius: Established in 1999, a highly r...

    Day In a Page

    The difference between America and Israel? There isn’t one

    The difference between America and Israel? There isn’t one

    Netanyahu knows he can get away with anything in America, says Robert Fisk
    Families clubbing together to build their own affordable accommodation

    Do It Yourself approach to securing a new house

    Community land trusts marking a new trend for taking the initiative away from developers
    Head of WWF UK: We didn’t send Cameron to the Arctic to see green ideas freeze

    David Nussbaum: We didn’t send Cameron to the Arctic to see green ideas freeze

    The head of WWF UK remains sanguine despite the Government’s failure to live up to its pledges on the environment
    Author Kazuo Ishiguro on being inspired by shoot-outs and samurai

    Author Kazuo Ishiguro on being inspired by shoot-outs and samurai

    Set in a mythologised 5th-century Britain, ‘The Buried Giant’ is a strange beast
    With money, corruption and drugs, this monk fears Buddhism in Thailand is a ‘poisoned fruit’

    Money, corruption and drugs

    The monk who fears Buddhism in Thailand is a ‘poisoned fruit’
    America's first slavery museum established at Django Unchained plantation - 150 years after slavery outlawed

    150 years after it was outlawed...

    ... America's first slavery museum is established in Louisiana
    Kelly Clarkson: How I snubbed Simon Cowell and become a Grammy-winning superstar

    Kelly Clarkson: How I snubbed Simon Cowell and become a Grammy-winning superstar

    The first 'American Idol' winner on how she manages to remain her own woman – Jane Austen fascination and all
    Tony Oursler on exploring our uneasy relationship with technology with his new show

    You won't believe your eyes

    Tony Oursler's new show explores our uneasy relationship with technology. He's one of a growing number of artists with that preoccupation
    Ian Herbert: Peter Moores must go. He should never have been brought back to fail again

    Moores must go. He should never have been brought back to fail again

    The England coach leaves players to find solutions - which makes you wonder where he adds value, says Ian Herbert
    War with Isis: Fears that the looming battle for Mosul will unleash 'a million refugees'

    The battle for Mosul will unleash 'a million refugees'

    Aid agencies prepare for vast exodus following planned Iraqi offensive against the Isis-held city, reports Patrick Cockburn
    Yvette Cooper: We can't lose the election. There's too much on the line

    Yvette Cooper: We can't lose the election. There's too much on the line

    The shadow Home Secretary on fighting radical Islam, protecting children, and why anyone in Labour who's thinking beyond May must 'sort themselves out'
    A bad week for the Greens: Leader Natalie Bennett's 'car crash' radio interview is followed by Brighton council's failure to set a budget due to infighting

    It's not easy being Green

    After a bad week in which its leader had a public meltdown and its only city council couldn't agree on a budget vote, what next for the alternative party? It's over to Caroline Lucas to find out
    Gorillas nearly missed: BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter

    Gorillas nearly missed

    BBC producers didn't want to broadcast Sir David Attenborough's famed Rwandan encounter
    Downton Abbey effect sees impoverished Italian nobles inspired to open their doors to paying guests for up to €650 a night

    The Downton Abbey effect

    Impoverished Italian nobles are opening their doors to paying guests, inspired by the TV drama
    China's wild panda numbers have increased by 17% since 2003, new census reveals

    China's wild panda numbers on the up

    New census reveals 17% since 2003