Gilts regain their edge as bonds enter danger zone

Melanie Bien looks at the case for investing in government debt

Corporate bonds have long been a safe haven for savers and inves- tors trying to avoid volatile stock markets and poor returns on savings accounts.

But while institutional investors believe these products have had their day and are shifting their money into riskier high-yield or "junk" bonds, a number of bond managers are suggesting that a return to gilts or government debt is a wiser move.

Boutique investment house Thames River Capital thinks the big gains have already been made in investment-grade bonds, and that gilts are the next step. Paul Thursby, co-manager with Peter Geikie-Cobb of its new Global Bond fund, which launches on 24 October, believes that if investors don't switch from corporate bonds into gilts, it could prove costly.

"Losing money will become a possibility for bond investors as it has been for those in equities," he says. "This is probably the most dangerous time for fixed-income investors in 20 years. Corporate debt issuance has exploded ... and has had a powerful effect on investor preferences, reminding us of the dot-com bubble of 2000."

Mr Thursby's fund will have no exposure to corporate debt. Instead it will focus on the highest-quality government debt across the world. "Bonds are supposed to diversify an equity portfolio and to defend investors against deflation," he says. "But corporate bonds don't do that. The bond market is going to reprice and government debt will be much more attractive because it will be secure."

Bonds are IOUs issued by governments or companies to raise money. The holder gets a fixed level of interest during the life of the bond - the yield - as well as their capital back on a set date.

Persuading investors to give up their corporate bonds may be tough, given their recent stellar returns. The average UK corporate bond fund has pro- duced 20 per cent growth in the past three years, compared with a 25 per cent fall in the average UK equity fund.

But gilts have started to look more tempting in the past couple of months, with yields of around 4.7 per cent - not bad in the current environment.

James Foster, head of fixed-interest investments at Isis Asset Management, who a few months ago was singing the praises of high-yield bonds, is also a convert. Some 70 per cent of his Strategic Bond fund is in high-yield bonds as he remains "convinced this is where the action will continue to be". However, gilts are starting to feature.

"I've started building up a tactical position in long-dated gilts," he says. "Over the next week I anticipate shifting about 7 per cent of the fund into these stocks."

Rod Davison, head of fixed interest at Aberdeen Asset Management, also recommends that cautious inves- tors should put more of their portfolio in gilts if they are worried about the performance of corporate bonds.

The shift towards gilts comes just months after their popularity was at a low. Corporate bonds may be riskier but they have also produced better returns; gilts are safe but returns have been unimpressive. And Gordon Brown's decision last year to issue more government debt pushed gilt prices down amid fears that the market would become swamped.

But now sentiment is changing. "If you don't think interest rates are going to go up, and I don't, then gilt yields look more attractive," says Mark Dampier, research director at independent financial adviser (IFA) Hargreaves Lansdown. "Gilts are much better value than they were seven or eight weeks ago."

Sue Whitbread at IFA Chartwell agrees. "Yields on gilts are looking more attractive because the price of these bonds has fallen so much," she says, "but there is more risk at the longer end. I would opt for gilts under five years, as gross redemption yields will be more than 4 per cent."

She advises investors to buy gilts direct from their stockbroker, the Bank of England's brokerage service, the Debt Management Office or the Post Office.

"If you buy through a fund you will pay a management charge," she warns. "And if redemption yields are 4 per cent, charges will have a significant impact. You don't need to diversify in the same way with gilts as you do with corporate bonds because one gilt is as secure as any other so you may as well buy direct."