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Will the bonds bubble burst?

Small investors are pouring savings into bond funds to avoid stock market turbulence. Patrick Collinson reports

Saturday March 22, 2003

The Guardian

Corporate bonds have been the perfect safe haven during the turbulent stock market. While the average UK growth unit trust is down by 41.5% over the past three years, the average UK corporate bond fund is up 18.1%.

Small investors are pouring money into bond funds in their droves. Corporate bonds have been at the top of the best sellers list every month for the past seven months, and advisers expect them to be the most popular stock market Isa this year.

But the surge in sales is provoking concern in some quarters. Is there a dangerous bubble in bonds, akin to the technology bubble that burst in 2000? Brian Dennehy of financial advisers Dennehy Waller thinks so.

Last September, he issued a warning about the many hidden risks in bond investing. Chief among these is inflation, which destroys the value of bonds. Now he is concerned that bond fund managers are failing to protect investors from the possibility of deflation.

Deflation is no friend to bond investors: in the early 1930s, according to Mr Dennehy, triple-B bonds on Wall Street made capital losses of an average of 56%. Even triple-A bonds saw losses of 23%.

His conclusion? Avoid high-yield and head for triple-As and gilts only. "Funds with higher quality bonds will provide diversification in a deflationary environment, when equities and many other bonds will be falling sharply, and there is a flight to quality."

But M&G, which runs the UK's biggest corporate bond fund, is adamant that bonds are safe and will continue to offer decent, low volatility returns. M&G's bond chief Jim Leaviss says: "Bonds have now outperformed equities over a 10-year plus timescale, and with less risk too. The good news for bond investors? There's no reason why this can't continue."

Mr Leaviss says bonds will be supported by weak global growth and subdued inflation. He believes the rate of inflation will fall back soon, partly as oil price hikes drop out. But it does not fear outright deflation, except perhaps in Germany.

The central message is to expect more rate cuts in the UK, US and Europe.

But should investors buy funds investing in low-yield triple-A bonds, or plump for riskier, but higher yielding funds investing in triple-B bonds? Mr Leaviss says the best value is in high yield bonds. "High yield definitely warrants a second look. We see a lot of value in triple-Bs corporate bonds."

These bonds are from companies which have been through the pain of recession and cutbacks and whose cashflow is relatively secure.

Dr Keith Wright from North Wales is the first winners in our Investor of the Year 2003 challenge, sponsored by fund management group Artemis and run in conjunction with The Observer and Money Observer. Dr Wright's gain of 0.89% wins him £150 in cash plus a weekend break at a Marriott hotel.

Second place was won by David Meek from Buckinghamshire, with a gain of 0.64%, followed by Janet Ferguson from Thurso in Caithness, Hugh O'Kane from Belfast and Dr Tariq Hamid from Kennington in London. Each will receive £100.

Worried? Play safe with a cash Isa

For cautious investors who don't like the look of the stock market and believe bond funds are also too risky, a cash Isa is a safe bet. You can earn 4%-plus with a cash Isa and your capital is completely secure.

However, the April 5 deadline for using this year's Isa allowance is drawing near. You can put £3,000 into a cash Isa in any one tax year, and the majority of accounts allow you instant access to your cash.

Best buys include Northern Rock's 30-day notice mini cash Isa, currently paying 4.45%, though this rate will fall to 4.2% on March 31 following the last base rate reduction. This rate includes a 0.55% interest bonus for the first six months.

Monmouthshire building society is paying 4.25% on its instant access Isa while those of fering 4.2% include the banking arm of supermarket Safeway, Chatham-based Kent Reliance building society and West Midlands-based Tipton & Coseley building society.

Phone and internet bank Intelligent Finance recently bucked the trend of falling Isa rates by raising its rate from 3.7% to 4.05% and has also introduced a guarantee to pay at least 0.3% above the base rate until April 5, 2004.

Meanwhile, National Savings & Investments index-linked savings certificates are looking interesting. The rate on index-linked certificates is pegged to the RPI, currently 3.2%, plus you get a fixed amount - currently 0.5% on the two-year certificate and 0.8% on the five-year. All returns are tax-free.

Rupert Jones
Guardian Unlimited © Guardian Newspapers Limited 2003

(posted 7678 days ago)

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