Gilts may be 'safe', but they're not glittering

These are strange days indeed. The UK, despite one of the highest budget deficits of the world's major economies, is being viewed as something of a "safe haven" by international investors.

So much so that the rate of return on 10-year UK government debt reached an all-time low on Friday, and is now very close to that of Europe's powerhouse economy, Germany.

Despite the eurozone crisis, or perhaps because of it, the latest figures show money is being pulled out of funds investing in shares and moving into funds holding gilts. Investors pumped £111m into UK government bond funds in September, according to the Investment Management Association, marking the highest level of interest in gilt funds since December 2008, the height of the credit crisis.

But the huge demand for UK bonds has meant they are now offering extremely unattractive returns. Gilt prices have risen to the extent that investors are prepared to accept a lowly yield of around 2.1 per cent on 10-year government bonds, a return which is well below the UK's 5.2 per cent inflation level.

And "safe-haven" gilts do not come without risks, a warning echoed by many fund managers and financial advisers. Paul Read, the manager of a range of Invesco Perpetual bond funds, says: "While safe in nominal terms – you will get your money back – as an investment in real terms you are almost certainly looking at negative 'real' returns after accounting for inflation."

By buying gilts, people are lending money to the Government in return for a fixed rate of interest. Investors receive their money back as long as the Government does not go bust or default on payments. The British government has never defaulted on its debts, supporting the view that gilts are one of the safest investments available in the UK. However, Patrick Connolly, from independent financial advisers AWD Chase de Vere, says: "Although gilts are safe investments, at current prices it is entirely possible that investors could see some fairly significant capital losses."

For investors seeking higher returns than those offered by gilts, bonds issued by companies rather than the Government can deliver better yields. Corporate bonds are generally not as safe as gilts, as there is a far greater chance that firms could go bust, and so offer a higher rate of interest to attract investors. Yet, with Europe on the brink of recession and with many banks facing difficulties over their sovereign debt exposure, investors would be forgiven for exercising caution when considering corporate bonds.

Rather than buying individual bonds, investors would be better off diversifying through funds. Mr Connolly says: "While there will be additional charges for buying collective funds, the extra diversification and protection means this is a sensible approach."

Gavin Haynes, the managing director of Whitechurch Securities, says the compelling yields of many corporate bonds more than compensate for the extra risk. "Although perceived higher risk," he says, "in fact, many multinational companies have balance sheets that appear much stronger than many large Western economies."

But if you do not want to take on the higher risk of corporate bonds, there are fixed-income funds which provide diversification by owning different types of bonds. In the UK, the three main types of fixed income investments are gilts, investment-grade corporate bonds, and high-yield bonds. Mr Connolly says: "Strategic bond funds are a good way for investors to get exposure to investment grade bonds, high yields bonds and other fixed areas. Funds that we like include Fidelity Strategic Bond, Kames Strategic Bond and M&G Optimal Income."

Yet investors must be careful that they understand the different types of fixed income and the risks involved. The riskier fixed-interest investments, such as high-yield bonds, tend to move more in line with stock markets, and so, even though they have the potential to provide better returns, they should only make up a part of your overall fixed-interest exposure.

Darius McDermott, the managing director of Chelsea Financial Services, says high-yield bonds offer the greatest risk-and-reward profile at the moment, as gilts are over-priced, particularly due to the recent influx of money. However, high-yield bonds are issued by companies with the lowest credit rating, meaning these firms are more likely to default. In comparison, investment-grade bonds are less risky, as they are issued by firms with the best credit ratings and are therefore less likely to default. Although investment-grade bonds do not pay out as much as high-yield bonds, they offer a higher yield than gilts.

There are other risks to be aware of when buying either fixed-income funds or individual bonds. Mr Haynes says: "While fixed interest does have a part to play in a balanced portfolio and can provide an attractive income flow, it is important that investors do not look at enticing yields as a direct substitute for cash. These investments have risk attached and if interest rates or default rates increase, such investments can suffer capital losses."

In keeping with not putting all your eggs in one basket, Mr Haynes favours strategic bond funds, which can invest in a range of different types of bond. He adds: "The Jupiter Strategic Bond managed by the highly rated Ariel Bezalel, and M&G Strategic Bond under Richard Woolnough and M&G's extensive bond team, are both good choices."

Emma Dunkley is a reporter at citywire.co.uk

Expert View

Gavin Haynes, Whitechurch Securities

"High demand for gilts has pushed prices up and yields down to extremely unattractive levels. Corporate bonds, where much higher yields are on offer, currently provide a more attractive proposition. Strategic bond funds that provide managers with flexibility to invest across the fixed-interest spectrum are a good choice for investors seeking exposure to this asset class."