Bad news for bonds?

Investors have filled their pockets with bond funds over the last few years, but experts are now warning that the good times could be over.

Bonds are IOUs issued by the government or companies that pay a fixed rate of interest to investors until the capital is repaid at the end of the term. Although bonds are traded on the stock market, their prices tend to be less volatile than shares and they usually pay a higher income.

These features have made specialist bond funds particularly attractive to private investors in recent years. But after several years of good returns and the possibility of higher inflation on the horizon, advisers are warning bond fund investors that they need to be prepared for much lower returns in future.

Brian Dennehy of independent financial advisers Dennehy Weller says investors will have to adjust their expectations. He points out: 'There is no doubt that bond funds have provided superb returns over the last 10 years, better than equities in some cases. But that period was exceptional and investors shouldn't expect those returns to continue.'

He is concerned that tied agents - particularly some of the high street banks - have been selling large amounts of bond funds over the past year despite the deteriorating outlook.

The reason bond funds have done so well in recent years is largely due to the prolonged period of falling interest rates and falling inflation. The resulting low interest rates on saving accounts increased demand for bonds and pushed up prices.

As a result bonds have become increasingly expensive and yields have shrunk, with government securities now offering about 4.2 per cent. Corporate bonds issued by companies still offer slightly higher yields, but they too have become expensive. There is growing concern that the current situation is unsustainable and that a fall in bond prices is imminent.

But not all bond fund managers are pessimistic. Stephen Snowden, manager of Old Mutual Corporate Bond fund says: 'People have been trying to talk bonds down for a couple of years and it has not borne fruit. This year has actually turned out to be pretty good. Our fund has produced a total return of over 7 per cent and there is still the fourth quarter to go which is traditionally strong for bond markets.'

Recent bond fund launches have emphasised the need for flexibility. They have included Artemis Strategic Bond fund which can invest in any type of bond anywhere in the world, and Threadneedle Absolute Return Bond fund which can also invest in derivatives and go short, allowing it to make money even if bond markets fall, and helping it achieve its target return.

Nobody is suggesting that existing investors should dump their bond funds if they have been bought as part of a balanced portfolio. However, Dennehy says: 'My concern is with people who have been encouraged to put all their non-savings account money into bond funds. They should look into using other funds such as commercial property and equity income funds.'