Why bond owners will get burned

Investors are buying 'safe haven' British bonds, but the UK's IOUs are ticking time-bombs!

There’s no way I’d buy UK government bonds right now. Here's why...

What is a bond? 

A bond is an IOU: a debt issued by a country, company or other organisation to help fund its needs. 

When an investor buys its debt, a bond issuer agrees to pay the buyer 'coupons' -- a fixed income throughout a bond's life. When a bond 'matures' -- after, say, 10 years -- investors are paid the bond's original issue price (known as 'par value'). Bonds are fixed-income investments, because their regular coupons are fixed during their existence. 

Read more in Why gilts matter.

The name's bond 

Although the US is the biggest bond issuer, the UK is a sizeable player. In March, the total value of outstanding UK bonds (known as 'gilts') was £1,164 billion, with most of this debt issued in the past four years. 

Since the global crash of 2007/09, investors have increasingly viewed gilts as a safe haven in the financial storm. Due to this constant buying pressure, gilt prices have soared. As their income is fixed, rising gilt prices cause their yields (their effective interest rates) to fall. 

Read more in Bonds smash shares.

The lowest yields ever 

To show you how amazingly low gilt yields are, here's a table of leading countries' 10-year bond yields, sorted from lowest to highest: 

Source: FT.com, 31/05/12 

Today, the UK can borrow money for a decade in return at a fixed rate of 1.66% a year. This is the lowest yield in 309 years, since the Bank of England started monitoring bonds in 1703. 

This means that British bonds are regarded as among the safest bets in the world, together with Japanese bonds, German Bunds and US Treasurys. That's because the UK enjoys the world's highest credit rating: AAA. 

At the other end of the scale are bonds paying 'danger money', such those from Greece (30% a year), Portugal (over 12%) and Spain (nearly 7%). These high yields indicate struggling economies and the increased chance that these governments could default on their debts.

Four gilt-y secrets 

Though many investors regard UK gilts as a safe haven, I disagree, because these bonds have several drawbacks that make them truly terrible long-term investments. 

Here are four reasons why I wouldn't buy gilts today:

1.  Ludicrously low yields 

Buying a 10-year gilt is like lending money to our government for a decade for a fixed yearly return below 1.7%. This is an insane price to pay for safety, given the generous incomes available elsewhere. 

For instance, I can earn over 5% a year from the cash dividends paid by shares in Britain's strongest companies, such as drug giant GlaxoSmithKline (which I already own). Likewise, I can earn over 5% a year by buying corporate bonds issued by strong businesses such as mega-bank HSBC. I'd much rather bank these incomes than the pathetic payments on offer from gilts.

2.  Interest rates: the only way is up 

When interest rates rise, bond prices fall. This is because bond coupons are fixed, so when general rates start to rise, bond prices fall. This pushes up bond yields in line with the wider market. 

Since March 2009, the Bank of England's base rate has been stuck at 0.5% a year -- its lowest level since the Bank was formed in 1694. Eventually, the base rate will start rising in the coming years, pushing up general interest rates. As a result, bond yields will rise and gilt prices will plummet. 

Thus, unless gilt owners hold these until maturity, they will face big losses in the years ahead.

3.  Above-target inflation 

High inflation (when the cost of living is rising steeply) is bad news for bondholders. As bond coupons are fixed, high inflation undermines the future buying power of these payments, making them less attractive. 

The latest inflation figure, based on the CPI (Consumer Prices Index), was 3% in April, versus 3.5% in March. Although UK inflation is coming down, it remains a full percentage point above the Bank of England's CPI target of 2% a year. 

This above-target inflation means that gilt buyers earning a fixed 1.66% a year are guaranteed to lose out in 'real' terms, after accounting for inflation). Furthermore, I suspect this losing streak will continue for a while, giving gilts a negative real income.

4.  Rising credit risk 

The thing bondholders fear most is default, when a bond issuer fails to pay coupons or doesn't return the principal (the bond's value on maturity) in full. 

In more than three centuries, the UK has never defaulted on its debts and is highly unlikely to do so in the coming decade. However, with our national debt rising rapidly, the risk increases that Britain will one day fail its bondholders. Indeed, I strongly believe that this could happen in my lifetime (I am 44). 

Meanwhile, one thing is certain to happen before 2022: the UK will lose its prized AAA s credit rating. This happened to the US last August, when its rating was cut to AA+. Our turn is coming and, when this happens, gilt prices will fall, pushing up yields and increasing our debt interest. 

In summary, while owners of UK gilts have had a fantastic five years of rising prices and falling yields, this winning streak will end. When it does, I wouldn't want to own UK gilts at today's prices, because bondholders will get badly burned. 

Finally, one French fund manager, quoted by news agency Reuters, said recently, "The UK is running a first-class act. They are stealing 2% a year from investors". I agree, mon ami! 

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