Government bonds not such a good buy

All around the world governments are issuing bonds to raise money to counter the global economic crisis. Yet bonds carry a significant downside in capital risk, if inflation picks up, and pay low interest rates.

Bonds are always portrayed as an ultra safe investment but they are not bank account deposits. The value of a bond can, and does rise and fall according to interest rate movements.

When interest rates go up, bond prices go down, and vice-versa. At the moment global interest rates are being kept artificially low by the central banks, so interest rates do not reflect market rates.

Deposit rates

For a more true and fair view of where interest rates should be look at the six per cent term deposit rates on offer from UAE banks. This is where the market puts the value of money.

So if the market would like to set interest rates higher, does it make sense to buy bonds which are not only paying less interest but clearly very vulnerable to a fall in capital value?

It is always the same story when governments try to interfere with market mechanisms – which are only basic economic forces. They can get away with it for a short time but in the long-run economic forces always prevail.

Bonds might indeed enjoy some short-run upside, especially if equity markets reverse their recent rally in anticipation of possible bankruptcy proceedings at two of the largest US companies, General Motors and Chrysler.

But a safe, long-term investment is something that bonds are not likely to provide. Governments are inflating money supply all around the globe, and that is guaranteed to lead to inflation eventually. Inflation means that the fixed interest on bonds may actually become negative, and their value plummet.

Bond bubble

Swiss investment guru Dr Marc Faber says 30-year treasury bonds could be the worst investment class available to investors. A rush to this false safe haven could prove yet another disaster for the financial sector.

Indeed, bonds look the next asset class bubble ready to burst. What will governments do then? They will have to cut back expenditure, raise taxes and interest rates.

In that climate investors will flee to the last safe haven and create a final asset bubble in precious metals. Only when that bubble is burst will investment be back on safe ground, and those who invest in major asset classes at that point will get the very best long term performance.