Fixed Interest - Safe or Sorry?

After the recent high-profile auction of 50-year gilts, and with further tranches to come, we thought it timely to take a look at the UK gilt sector and see how it compares with alternative fixed interest offerings. What we found is startling.

This survey examines retail funds in the IMA's UK Gilt and UK Corporate Bond sectors. Our tables are taken from Financial Express's Analytics, and cover the three-year period to date.

Q: The returns from gilt funds are lower than those you could expect from bond funds, right?
A: Right.
Q: But on the upside, gilts are risk-free, or at least always much less risky than bonds, right?
A: Wrong!

In our first table, we examine the three-year total return performance of retail funds in the UK Gilt sector.

We can now compare those results with a selection of top funds in the UK Corporate Bond sector:

The best performing gilt fund, Morgan Stanley's UK Long Bond, returned 22.79% over three years. Invesco Perpetual's Corporate Bond outstripped this by 30%, at 29.53%.

In fact, there are 11 funds in the corporate bond sector that outperform the best of the gilts.

Nothing too controversial there then, given the sectors' differing investment areas. And given our expectations of the risk/reward relationship, the bond funds' performance will surely come at a cost of greater volatility.

Except that, unfortunately for received wisdom on this point of principle, in a significant number of cases this is simply not true.

Our ratios tables below reveal that every one of those 11 bond funds has lower volatility than the 6.95% of Morgan Stanley's gilt vehicle. Further, these 11 all have lower volatility than the top three gilt funds.

To find a leading gilt fund with volatility that does not exceed that of the 11 bondholders, you have to go to number four in the sector: Baillie Gifford's Gilt, at 4.00%. But to get into this comfort zone, more performance has to be sacrificed, and now there are 28 bond funds - out of 67 in the sector - that outperform BG's 20.15% return.

And investors in Invesco Perpetual Corporate Bond will have reaped their 29.53% while taking on a risk factor of just 3.86%. Alternatively, if even lower volatility is the principal criterion in fund selection, an investment in New Star's Sterling Bond would still have outperformed the best of the gilt sector, with volatility - at 3.05% - less than half that of the Morgan Stanley gilt fund.

Indeed, the New Star fund's volatility is lower than that of every member of the gilt sector bar three Solus offerings - but, taken as a group, these funds are still carrying an average 81% of the risk that New Star does, while generating only 41% of the bond fund's return.

If the New Star fund stands out as a good lower-risk performer in the corporate bond sector, its antithesis is to be found lurking among the gilts. Allianz Gilt Yield carries the highest level of risk - 7.85% - of all the funds in the two sectors we've examined. At the same time, it has returned just 3.31% over a 3-year period, and over more recent periods is losing money at an increasing rate. It has little or no correlation to its peer group, and the holders of the fund's £199m assets must surely be asking what on earth is going on here.

The 3-year sector averages, while less starkly contrasting than the extremes above, nevertheless bear out this paradoxical picture:

Corporate Bond - return 19.75%, volatility 3.88%
Gilt - return 15.73%, volatility 4.07%

• The common perception is that gilts are risk-free investments. This may be so, to a primary investor, but most people only have access to these instruments via a collective investment fund, and that's where things can go wrong.

• The UK Gilt sector unsurprisingly provides lower returns than corporate debt. But there is plenty of opportunity here to make an unfortunate choice, even among the top performers, which could have investors carrying higher levels of risk as well; and, in the worst case, taking on the highest volatility while watching their money trickle away.

• The good news that our survey points up is that in the corporate bond sector it is possible to achieve superior fixed interest returns, and a satisfactory answer to the perennial question, 'yes, but at what cost?'.

• But what is happening in the gilts sector, and what do these findings mean for people's perception of gilts as 'safe' investments?

• There seem to be two possible views: a) if you're expecting the level of return typical of gilt funds, don't take on the risk that they present - you'd do better to put your money on high interest deposit instead, or b) if you can accept the risk, don't buy lower-yielding gilts - there are plenty of corporate bond funds around that offer equivalent or lower volatility, and achieve higher returns to boot.