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; request a free guide on NISAs from Hargreaves Lansdown

Sport
A 'Sir Alex Feguson' tattoo
football

Arts and Entertainment
Liam Neeson said he wouldn't
tv

Liam Neeson's Downton dreams

Voices
voicesApple continually kill off smaller app developers, and that's no good for anyone
Voices
On the last day of campaigning before the polling booths open, the SNP leader has written to voters in a final attempt to convince them to vote for independence
voicesIs a huge gamble on oil keeping the First Minister up at night?
PROMOTED VIDEO
Arts and Entertainment
Ben Whishaw is replacing Colin Firth as the voice of Paddington Bear
tv

Thriller is set in the secret world of British espionage

Life and Style
life

News
ScienceGallery: Otherwise known as 'the best damn photos of space you'll see till 2015'
Travel
travelWhy Japan's love hotels are thriving through an economic downturn
Life and Style
fashion

Bomber jacket worn by Mary Berry sells out within an hour

Life and Style
Alexander McQueen A/W 2014
fashionPolitics aside, tartan is on-trend again this season
Arts and Entertainment
Rapper Jay Z performs on the Pyramid Stage at Glastonbury in 2008
musicSinger sued over use of the single-syllable sample in 'Run This Town'
Sport
Joel jumps over the board...and into a giant hole
footballFrom joy to despair in a matter of seconds
News
i100
Arts and Entertainment
Pointless host Alexander Armstrong will voice Danger Mouse on CBBC
tv

Much-loved cartoon character returns - without Sir David Jason

Arts and Entertainment
Meera Syal was a member of the team that created Goodness Gracious Me
tv

Actress to appear in second series of the hugely popular crime drama

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

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

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    SQL Developer - Watford/NW London - £320 - £330 p/d - 6 months

    £320 - £330 per day: Ashdown Group: The Ashdown Group have been engaged by a l...

    Head of Audit

    To £75,000 + Pension + Benefits + Bonus: Saxton Leigh: My client is looking f...

    Audit Manager Central Functions

    To £85,000 + banking benefits: Saxton Leigh: You will be expected to carry out...

    Credit Risk Audit Manager

    Up to £90,000 + benefits: Saxton Leigh: Credit Risk Audit Manager required to ...

    Day In a Page

    Mystery of the Ground Zero wedding photo

    A shot in the dark

    Mystery of the wedding photo from Ground Zero
    His life, the universe and everything

    His life, the universe and everything

    New biography sheds light on comic genius of Douglas Adams
    Save us from small screen superheroes

    Save us from small screen superheroes

    Shows like Agents of S.H.I.E.L.D are little more than marketing tools
    Reach for the skies

    Reach for the skies

    From pools to football pitches, rooftop living is looking up
    These are the 12 best hotel spas in the UK

    12 best hotel spas in the UK

    Some hotels go all out on facilities; others stand out for the sheer quality of treatments
    These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

    Widespread fear of Isis is producing strange bedfellows

    Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
    Topshop goes part Athena poster, part last spring Prada

    Topshop goes part Athena poster, part last spring Prada

    Shoppers don't come to Topshop for the unique
    How to make a Lego masterpiece

    How to make a Lego masterpiece

    Toy breaks out of the nursery and heads for the gallery
    Meet the ‘Endies’ – city dwellers who are too poor to have fun

    Meet the ‘Endies’ – city dwellers who are too poor to have fun

    Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
    Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

    Ian Paisley’s decision to make peace with his IRA enemies

    His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
    'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

    'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

    Exclusive extract from Janis Winehouse's poignant new memoir
    Is this the role to win Cumberbatch an Oscar?

    Is this the role to win Cumberbatch an Oscar?

    The Imitation Game, film review
    England and Roy Hodgson take a joint step towards redemption in Basel

    England and Hodgson take a joint step towards redemption

    Welbeck double puts England on the road to Euro 2016
    Relatives fight over Vivian Maier’s rare photos

    Relatives fight over Vivian Maier’s rare photos

    Pictures removed from public view as courts decide ownership
    ‘Fashion has to be fun. It’s a big business, not a cure for cancer’

    ‘Fashion has to be fun. It’s a big business, not a cure for cancer’

    Donatella Versace at New York Fashion Week