Ian Cowie (Personal Finance Editor of The Telegraph) was named Consumer Affairs Journalist of the Year in the London Press Club Awards 2012. He writes of his fears for the bond market ahead and how he has decided now is the time to get out. Once interest rates rise, bonds will get crushed in the stampede. Eventually one country will default on its bonds causing an increase in interest rates which will set off a chain reaction.

Last month I took the biggest bet of my life and, without wishing to overstate the downside, put 26 years’ savings at risk. Contrary to the conventional wisdom that people should raise their exposure to supposedly low-risk bonds and reduce shareholdings as they get older, I did the opposite and sold all the bonds in my company pension to buy shares.

That might be regarded as a recklessly risky thing to do for several reasons. First, bonds – a form of IOU issued by countries and companies – provide investors with a promise to pay income and repay their capital at fixed dates in the future, whereas shares give no guarantees at all.

Second, bonds have delivered higher total returns than shares for more than 20 years now. Third, bonds issued by the British Government, sometimes called gilts, are the basis of the annuities that most “defined contribution” or “money purchase” pensioners use to fund retirement.

So what on earth possessed me to sell all my bonds and beef up exposure to shares? The short answer is that I expect bond prices to fall when interest rates rise and suspect that shares offer much better long-term value. One reason bonds beat shares over the past two decades is that interest rates have plunged, pushing up the relative attraction of the fixed income that most bonds promise to pay.

Several other senior City figures fear capital destruction among risk-averse investors if the bond bubble bursts. Max King, portfolio manager at Investec Asset Management, told me: “The overvaluation of government bonds means that there is a risk of a sharp correction if the economic outlook improves, especially in America, but central banks appear determined to keep interest rates low and negative in real terms.

“A return of interest rates and bond yields to their historic trading range would be a clear sign of a return to normality for the global economy but could be disruptive for investors in the short term. We have very low exposure to developed economy government bonds as they offer plenty of downside risk without any upside.”

For example, most buyers of gilts today must accept “redemption” yields – those that reflect the total return – below inflation and a guaranteed capital loss on maturity. At current historic high prices and low yields, gilts do not offer a risk-free return so much as a return-free risk.

Even leading bond fund experts such as Stewart Cowley of Old Mutual Asset Managers are suffering bouts of vertigo.
He said: “If you look back on the history, bond yields have fallen from about 14pc in the early Eighties to eye-wateringly low levels today; a five-year maturity bond now yields about 0.7pc.

“This should be a sobering thought for investors in government bonds. At the very least nobody should be messing around with government bonds with maturities greater than about five years.”

But a trend is only a trend until it stops. Nearly four years after the Bank of England froze Bank Rate at 0.5pc there is precious little room left for further reductions and plenty of scope for rates to rise. If that happens, the apparent security that bonds provide could prove illusory.

It is quite mistaken to imagine that investments in gilts are as safe as the Bank of England; their stock market value can fall without warning. For example, when the Federal Reserve unexpectedly raised interest rates in 1994, bond prices – including those of UK gilts – suffered double-digit falls.

Never mind the history, though, what about the future? Robin Geffen, chief executive of Neptune Investment Management, predicts that bondholders could lose up to 40pc of their money when interest rates and inflation rise. He said: “The inevitable consequence of quantitative easing is that at some stage we are going to get high inflation, as central banks cannot print money forever to stimulate growth.

“When the cycle turns and we move from where we are now to interest rates rising, the long end of the bond market will go down by 30pc to 40pc.

“There are risks in both bond and equity markets, of course, but the risks in equity markets are well known. We believe that at some point a wave of money will flood out of bonds and into equities. If you are invested in the wrong part of the market, you will incur big losses.”

Source: The Telegraph