Back in the 1990s, investing in government bonds must have seemed like a no-brainer because the yield on 10-year US government paper was hovering around 9 per cent, which certainly sounds like a good deal these days. In the UK it was even higher, peaking at around 16 per cent.
The guarantee of a steady payout and your $100 being there in a decade must have been a soothing thought for many investors.
Fast-forward 20 years and the yields on US Treasuries and UK gilts had more than halved – to 4 per cent in April 2010.
By August that year, yields slid below 3 per cent and today they are languishing at 2.25 per cent for US bonds and 2.2 per cent for gilts, which is higher than a month ago, when both had slid south of the 2 per cent mark.
While professional and private investors alike have traditionally considered investing in government bonds "safe", with current yields this low, people are facing up to the fact that their money isn’t even beating inflation.
Effectively, you’re losing money while your bond matures because the cost of living has increased at a higher rate than your yield.
So is there any reason to continue holding bonds in your portfolio at these levels?
Star fixed income manager Richard Woolnough argues government bonds still have a place in investors’ portfolios because they still offer better returns than cash, albeit at much shorter durations than in the past.
"The government bonds that we own are all short-dated, with maturities of three to four years," he said.
"We hold these as a cash alternative. They are very low duration and risk. The other reason for holding them is that there has been less value in the market recently."
"High yield has not been as attractive as it was and we have not been buying it for a couple of months, until the past few days. Now it looks more attractive again."
"The fund’s neutral position would be one-third in government bonds, so it shouldn’t be that surprising," he added.
The FE Alpha Manager heads up the £14.5bn M&G Optimal Income fund, which has shifted further into government bonds as Woolnough saw value eroding from the market.
"We have been moving out of index-linked gilts and into conventional gilts. We moved out of them because they performed so well versus conventionals."
"Our only index-linked gilt holding matures in two months and so effectively trades as a conventional now."
"When linkers look cheap, we own them. At the moment, however, we own no government linkers and only a few corporate ones. Linkers are not generally a major position for the fund, although in 2011 we did find UK linkers attractive."
"If index-linked gilts fall another 30 to 40 basis points, back to the levels where they were trading at the beginning of the year, then we may start to buy again."
While Woolnough says holding government bonds is still worthwhile, he has recently moved to his highest ever weighting to equities in his M&G Optimal Income fund, at more than 11 per cent.
However, the only holding that is not US, UK or German government debt that has a place in his top-10 is US tech giant Microsoft.
M&G Optimal Income has been one of the best performers in the IMA Sterling Strategic Bond sector over three and five years, and has beaten its peers over 12 months.
Since launch in December 2006 it has made 73.61 per cent, compared with 32.42 per cent from the sector.
Performance of fund vs sector since launch
Source: FE Analytics
Iain Buckle, manager of the five crown-rated Kames Ethical Cautious Managed fund, says his allocation to bonds is the lowest it has ever been.
The fund, which is the best performer over three years in the IMA Mixed Investment 20%-60% Shares sector, is only holding 38 per cent in fixed income and Buckle says this allocation is almost entirely in corporate debt.
"I think we’re at the bottom of the interest rate cycle and I’d rather hold equities and cash than fixed income," he said.
He adds that there is still reasonable valuation in corporate credit compared with government bonds, but he remains hedged against interest rate risk, which he expects to "gradually drift higher" from here.
Andy Merricks (pictured), head of investments at Skerritt Consultants, disagrees with Buckle and says he has no government bond exposure in any of his client portfolios. "We won’t have any government bonds. I just don’t see the point," he said.
"It’s not worth it for the risk you are taking with what you are getting from government bonds."
Merricks instead favours equity income, where investors can benefit from a strong rally in equities and compound those returns by reinvesting the dividends over the long-term.
