Beat the bubble with second-rate bonds

Bubble' has become an ugly word among investors following the pain inflicted when the technology bubble popped three years ago.

So what are we to make of warnings that a bubble has inflated in the bond market, which could be about to burst in an equally damaging fashion?

Thousands of savers piled into bonds over the past two years in the belief that they were less risky than shares. Should they now be cashing in and heading for the building society, or even the box under the bed, as the only really safe place to put their money?

Describing bonds as 'safe' is misleading. The only thing that is pretty solid is the interest payment on a gilt-edged bond (effectively a loan to the Government) and on the top-rated, or AAA, investment-grade bonds, so-called because they are loans to companies whose financial strength gives them a credit rating almost as good as the Government.

Less solid companies can, and do, fail to pay the interest on their bonds - indeed in recent years some investment-grade companies have defaulted on their payments.

But, even if the income is secure, the price of the bonds can go up, as they have for much of the past three years, or down, as has been happening in the past few weeks for top-quality and government bonds. The fluctua tions should be less dramatic than in share prices, but anyone investing in bonds should be prepared for the value of their investment to fall, with the compensation that their income should remain reasonably steady.

It should be clear from that explanation that not all bonds are the same. James Gledhill, who runs New Star's bond funds, sums this up by saying that government bonds, and the AAA bonds that mirror them, enjoy insecurity. If the economic outlook is poor, investors are uncertain and no one wants to take risks, they will do well. So funds investing in these top-rated bonds have been the best performers over the past three years.

Lower-grade bonds, and particularly those rated as 'junk' or CCC, like security. A buoyant economy, falling interest rates and confident investors will boost their prices. So, over the past six months or so, when it became clear that the global economy was not going to collapse, these have done better than higher-rated issues.

Both have continued to rise: M&G calculates that AAA bonds have risen by 3.4 per cent so far this year while high-yield bonds have risen by more than 10 per cent.

That changed late last month, when the US Federal Reserve cut interest rates by just 0.25 per cent when the markets had expected a 0.5 per cent cut.

Until then, the Fed had been promising to cut rates to the bone and to boost spending to ward off deflation. Last month, deflation was not even mentioned: instead, the Fed predicted faster-than-expected growth in the second half of the year.

While deflation is good for government bonds, strong growth is bad. The result was a sharp rise in yields on government bonds , which means investors lost 2.75 per cent in less than a month.

But that does not mean we are doomed to a bear market in bonds. We have been warning since last autumn that the price of government bonds was getting too high and advising investors to switch into higher-risk issues. That advice still stands. Both categories remain attractive, provided you realise that the capital value of your savings is not guaranteed.

Jim Leaviss, manager of M&G's gilt and fixed-interest fund, thinks the Fed was over-optimistic about economic growth. While there may be a couple of good quarters, 'longer term, disinflationary forces will dominate and growth will remain below trend. A bursting of the so-called bond bubble is highly unlikely in this environment'.

New Star's Gledhill is a bit more gloomy about the outlook for government bonds which, he thinks, could weaken further in the coming months. Our own and the US government will have to issue more bonds to finance their budget deficits, so supply is likely to increase.

Lower-rated companies are doing all they can to please their lenders by cutting costs and selling businesses. They still offer better value for buyers.