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.