In my view, government bonds exhibit a high risk of loss. Even if all turns out well, the returns are going to be pitiful. In recent years, a good deal of the return provided by them is an illusion of wealth from capital appreciation, and cannot be realised unless you sell today.

The UK Gilt market has been manipulated by the Bank of England’s purchases of these bonds via quantitative easing. It now owns approximately 30% of the entire outstanding quantity of UK government bonds. The new rules for capital adequacy and perhaps the beginnings of financial repression, have also seen the UK banking sector ownership of these bonds increase to 10% of the debt outstanding. Such demand, combined with the fact that the cost of credit is basically free for the above entities, has inevitably driven down yields on UK government debt to the following historical low levels.

These low yields are despite the fact government finances are in disarray.

It get worse when you include the future transfers of wealth necessary to make good on state promises of a wide range of health related costs due to an ageing population, a century long use of pension ponzi schemes, and the increasing costs of a welfare state; it is clear that a larger portion of government taxes will towards meeting these historical promises made plus the official debts already incurred. It leaves little room for the things the government is meant to be funding such as security, infrastructure and essential services, and yet our politicians remain focused on expanding the definition of essential when it comes to their involvement in the economy and our lives.

This will all inevitably increase pressure on government finances. Even today this issue is apparent and it is likely to only become worse.

For example, we currently spend approximately £115billion on State Pensions and Credits (or 6.8% of GDP), which is broadly equivalent to the combined expenditure on Defence (£38billion), Transport (£23billion), Public Order and Safety (£32billion) and Housing and Environment (£25billion). Additionally, even at such manipulated and suppressed debt repayment levels, we are still paying out £53billion a year in interest on our existing debts. Even more concerning is our inability to get a grip on the situation. With all the austerity posture and cutbacks, you would be right to feel confused by the fact that we have borrowed a further £107.7billion in the 2013/14 tax year alone. (Source – Guardian article)

Despite this mess, I acknowledge that an outright default on UK Government bonds is highly unlikely as, in theory, we can pay these debts by QE and the electronic printing press (fraudulently creating additional numbers out of thin air). However, all other factors being equal, that will lead to a reduction in worth of prevailing money and inflation of prices.

Putting aside the real risk of not being able to purchase the same value of goods with these bonds in the future as you can today, there is a significant risk of depreciation in bond prices if the Bank of England decide (or are forced) to stop or reverse QE and increase interest rates.

This is by no means a perfect reflection of what will actually happen to Gilt prices during rising interest rates as Modified Duration is an imperfect measure. Worryingly, a quick look at the Bank of England’s historical rates indicate that 4% is quite a low rate of interest. We could well go higher.

While not a predictor of losses, the table should prove useful in highlighting the risk of investing in UK Government Bonds.

Financial professionals have been taught in academic textbooks and classes that government bonds offer a risk free return and yet history proves this to be false.

In 2009, Investec Fund Manager Max King pointed out that:

“An investor who bought the 3.5% War Loan for £18 in 1974 could have sold it for £88 in early 2009 generating a compound return of 24% pa. However it was originally issued at par and in 1932 was trading so far above par that the government was able to force through a cut in the coupon from 5%. Bond markets have not always been safe and low risk.

Bond Fund Manager Stewart Cowley of Old Mutual Wealth also noted that:

“If you look back on the history, bond yields have fallen from about 14pc in the early Eighties to eye-wateringly low levels today; a five-year maturity bond now yields about 0.7pc. This should be a sobering thought for investors in government bonds. At the very least nobody should be messing around with government bonds with maturities greater than about five years.

(emphasis added)

An over reliance on financial theory without consideration of the purchase price has at a retail level, led to owners of government bonds tending to be ‘low risk’ investors. Financial advisers who follow the prevailing financial theory will invest their client’s funds into this asset class today and expose them to serious risk, without any conceivable return provided to make this risk remotely worth taking.

An investor today is clearly taking a very different risk to an investor in the seventies.

Whilst one of the ‘best performing’ asset classes in 2014 was government bonds with the Vanguard UK Government Bond Index Fund providing a ‘return’ of 17.8% for the year, in light of the pitiful yields on offer at the start of 2014, that ‘return’ was almost entirely an escalation in the prevailing government bond price.

This means only a limited number of investors will be able to obtain this ‘return’, as any attempts to sell in a large quantity will inevitably drive down the price, unless of course the Bank of England embarks on ever greater amounts of monetary lunacy and buys them.

I expect only nimble speculators to benefit from the escalation in bond prices, with investors only likely to experience temporary paper profits. This will make their investment statements look impressive and reassuring, but it is my belief that this is merely an illusion of increasing wealth and the return to reality will prove painful.