Are gilts really a safe bet?

If you have been seeking a safe investment haven during the recent economic turmoil, you may have been tempted to invest in the government bonds that have flooded onto the market, in a bid by Chancellor Alistair Darling, to shore up the UK's finances.

Also known as gilts, these bonds enable investors and institutions to lend money to the government in return for a fixed rate of interest.

An impressive number of gilts have been released recently. However, their performance has been less than dazzling.

According to Morningstar, the average Investment Management Association UK gilt fund has fallen by 0.91% over the year to February. Over the same period, the average equity fund in the UK All Companies sector has risen by 29.1%.

"In 2008, as the credit crunch took hold, extreme risk aversion and falling interest rates created huge demand for gilts," says Gavin Haynes, managing director at independent financial adviser Whitechurch Securities.

"However, in 2009, as it became apparent that the worst case economic scenario of global depression had been averted, investors moved from lower-risk areas such as gilts into riskier assets such as corporate bonds and equities, resulting in a strong recovery in these areas and strong outperformance versus gilts recently."

Gilts may be viewed by many as the ultimate safe haven, but is now the right time to put money into them? Are they still the safest available investment? Here we answer your questions about this asset class.

Q: What are gilts?

A: Gilts are basically IOUs from the government. They are traditionally issued at a price of £100 each and redeemed at £100 on a predetermined maturity date. A fixed rate of interest is paid on them each year until this date.

Gilts are denoted by a combination of the coupon rate and maturity date – '4% Treasury Gilt 2016', for example. Plenty of gilts are always available in the market for investors to buy. Most gilts have maturity dates of five, 10 or 30 years.

Q: Is there more than one type of gilt?

A: Several types of gilt are available, but generally the market can be split into two areas: conventional gilts and index-linked gilts. What you decide to buy will depend on the economic climate at the time and your preferences.

With conventional gilts, the government agrees to pay a fixed cash payment – called a coupon – every six months until the maturity date, at which point the initial sum invested is returned. These gilts are divided into short-, medium- and long-dated gilts to reflect their remaining terms.

Index-linked gilts work in a similar way. However, the coupon and the original investment are adjusted in line with the retail prices index measure of inflation to take into account inflation since the gilt was issued. The method used to calculate these cash flows will vary.

Q: Are gilts still a low-risk investment?

A: Gilt payments are guaranteed by the Treasury and are safe unless the government goes bust and defaults on its payouts.

"Despite the perilous state of the economy," says Haynes, "it is very unlikely that you would not receive the return of your original investment together with the promised interest payment (coupons).

Providing you buy a gilt at issue and hold it until maturity, you should receive your original investment and regular interest."

However, it's important to understand that, in so far as gilts are safe, they are only safe if they are bought when they are issued and held until they are redeemed. Between times, their price can rise or fall. If you buy or sell at the wrong time, you can lose out.

Bear in mind, too, that should inflation rear its head, gilts would provide poor returns in real terms, as they provide a fixed level of income.

"An investment paying 4% (currently, a typical yield on 10-year gilts) would not be attractive in real terms if inflation increased markedly," says Haynes - unless it was an index-linked gilt that provides inflation-linked returns.

Q: How can I invest in gilts?

A: There are two main ways to invest in gilts. You can buy them new through a government department called the UK Debt Management Office (DMO) or secondhand on the stockmarket – usually through a stockbroker.

One of the cheapest ways of buying and selling small amounts of gilts is through the DMO. However, it operates on an execution-only basis, so you must know which gilts you want to buy or sell.

This route involves no advice being given. The gilts being auctioned and the dates they will become available are announced by the DMO at the end of every quarter.

To buy gilts that are already in issue, you can use the Bank of England brokerage service on the Bank of England website. You may well find this service has lower commission charges than a stockbroker.

Q: What about investing through a fund?

A: You can, of course, choose a gilt fund run by a specialist manager. There are plenty of these to choose from, whether you want exposure to conventional or index-linked gilts.

Two main types of fund focus on government securities. With an actively managed fund, an investment manager will build a portfolio of securities aimed at beating the equity market.

With gilts, this normally involves deciding whether to invest in short-, medium- or long-dated gilts. Specialist index-linked bond funds are also available.

Q: What about fees and charges?

A: This is an important consideration. While fund charges are significant with all funds, they are especially so with funds at the low-risk end of your portfolio.

"Most people buy bond funds for steady, unexciting returns," says Jason Witcombe, an IFA at Evolve Financial Planning.

"If your expectation of a particular fund is that it will produce returns of, say, 2% or 3% a year above cash, but there is an initial charge and then an annual management charge of 1% to 1.5% a year on that fund, a huge proportion of the return that you expect is being eaten up by charges."

Q: How are gilt markets looking around the globe?

A: With interest rate policies globally moving close to zero and investors becoming highly risk averse, government bond markets in developed countries have generally performed well since 2007. However, like the UK, many European economies have high levels of public sector debt.

Darius McDermott, managing director at Chelsea Financial Services, says: "There are currently huge fears over the health of the European bond fund market – some of which are justified given the parlous economic situations in the unkindly named PIGS countries [Portugal, Ireland, Greece and Spain].

In the US, a reversal of the current loose monetary policy could put pressure on treasuries. As a result, a small but significant number of investors are turning away from the developed nations and looking to the less debt-laden emerging markets."

Looking ahead, the attractiveness of overseas global bonds for investors will largely depend on how long interest rates stay low and when inflationary pressures emerge.

Investors choosing to invest in overseas government bonds need to be aware that they are going to be exposed to currency risk, which can be more volatile than the bonds themselves.

Q: What next for gilts?

A: The Barclays Equity Gilts study published in February predicted that equities will outperform government bonds over the next 10 years, and that they will give an average return of 6.3% a year, or 7.3% with dividends reinvested.

Meanwhile, government bonds are likely to achieve average returns of just 1.6%. Many experts agree that the future looks bleak for gilts.

McDermott says: "Many investors are nervous of gilts – due to the massive size of the UK government's debt and the worry that its credit rating may be downgraded from AAA to AA – and may be keen to avoid them over the coming years." However, he says he remains "neutral" on gilts over the next six months, as they may perform well if the UK economy and stockmarket do badly.

The outlook for the gilt market is uncertain, particularly with governments around the world running large budget deficits and bond issuance running at an all-time high. In the past, the market has easily absorbed increases in issuance because this has coincided with economic weakness and a flight to quality. However, the number of gilts now being issued is now so much higher than it has ever been that people are unsure what will happen next.

Q: So what should investors do?

A: No asset class can provide a solution in every economic environment, but Witcombe believes there is a place for gilts in most portfolios.

He says: "When talking about investment portfolios with clients, many are reluctant to hold fixed interest such as gilts and corporate bonds. They think these are boring and will add no value to the portfolio.

This is simply not the case. We believe that all portfolios should hold an element of fixed interest, with most clients holding upwards of 25% in this asset class."

It's important to have a mix of assets, depending on your medium- and long-term objectives, rather than plough into what looks attractive in the short term.

Many experts say that gilts can be part of this mix, by functioning as the part of an investor's portfolio that aims to produce a better medium to longer-term return than cash, without the volatility of equities.

Q: What are the alternatives to gilts for those who want a low-risk investment?

A: If you're looking for something low risk, but prefer to avoid gilts, there are really two options. One is to invest in cash.

Witcombe says you could opt for a cash equivalent investment, such as National Savings & Investments premium bonds.

Or you could take out a cash ISA or savings account, but as interest rates are still low, you won't get a high return. Another option is to invest in corporate bonds. While slightly riskier, these will produce higher returns, while remaining in the fixed-interest arena.

Q: What happens to gilts if interest rates rise?

A: If interest rates rise, the fixed coupons provided by government bonds look less attractive and prices in the secondary market tend to fall.

Investors may find second-hand gilts on the stockmarket less attractive than placing money on deposit, because the coupon and final redemption value are fixed.

If you think interest rates are about to increase, you might want to avoid government bonds for now. However, many experts forecast that interest rates will remain low for the foreseeable future.

Haynes makes another key point: "Bond markets anticipate future interest rates. By the time interest rates have risen, bond prices will have fallen."

Be aware that it is not just the base rate that shapes gilt prices. Inflationary expectations, the economic outlook, gilt supply and the time to redemption also have an effect.