Rate uncertainty takes the edge off gilts

It is hardly surprising that government gilts should have had a dismal few months. Rising interest rates - or, more precisely, the threat of them - usually spell bad news for bonds. Last week's rise had been predicted after the Monetary Policy Committee's October minutes revealed just how close it came to raising them in October, but now gilt investors are fretting about just how much further, and how quickly, they will rise again.

But it is not just interest rates causing worries about bonds. The US Fed started the jitters in the summer when it stopped worrying about deflation and started talking about the growth rate in the economy again. Deflation is good news for bond-holders, as it makes the promise that they will be repaid a fixed sum that has become more valuable, but inflation, which erodes the value of that sum, is bad news. And, while no one is yet talking about inflation being a problem, the strength of the latest economic figures from the US and the continued boom in consumer spending here means that it is more of a concern than it has been for some time.

The effect on returns has been dramatic. The chart shows that the total loss on government gilts since the Fed's comments in June has been more than 4.5 per cent. That has made gilt and bond funds among the worst performing over one, three and 12 months, according to analyst Lipper, which is doubly painful given that they have been one of the most popular sectors for retail investors for much of the year.

Now that the interest rate rises are actually happening, will the performance improve? James Foster, bond fund manager with Isis Asset Management, who not only predicted the poor recent performance but also warned investors against buying gilt funds, is still a bit anxious. 'We are getting to the time when they should be considered but I would still hold off for a little while yet.'

Jim Leaviss, who manages M and G's bond funds, says that the gilt markets are currently pricing in a rise in interest rates to 5.25 per cent by the end of 2004. If that is what happens, the bond markets should regain at least relative calm; investors are most content when everything happens as predicted.

The risk, however, is that the markets have once again got it wrong. Leaviss thinks that the prediction of a rise to 5.25 per cent is too pessimistic as a rise of that magnitude - equivalent to a 50 per cent increase from the low point before last week's hike - could do too much harm to heavily indebted consumers. Our borrowings have risen by 50 per cent since the start of 2000 and the cost of an extra 1.75 per cent interest on £906 billion of debt would be hard to swallow.

If he is right, bonds could recover some of the ground they have lost over recent months. But others think the dramatic rise in debt is the very reason that interest rates have to go up far faster than the market is expecting - that, they say, is the only way the Bank of England can persuade us to stop our spending spree. If that is right, bonds could have some way further to fall.

While government gilts have performed badly, high-yield bonds - the name for debt issued by companies with a lower credit rating - have been done relatively well. They have been encouraged by the fact that rate rises indicate an improving economy, so fewer of the issuers will default on their payments. If rates rise too fast, they too could suffer on fears that the economy will cool too quickly.

Bonds should form a much larger part of most private investors' portfolios: the rule of thumb is that the percentage in bonds should be the same as one's age, but it is currently less than 10 per cent for Pep and Isa investors. The current uncertainty means there is no need to rush in, however: investors could be better off waiting a couple of months, or dripping the money in through a regular savings scheme.