Go for security in era of change

This week's 0.25% rise in the base rate to 5.75% doesn't just affect mortgages and savings. Rising interest rates create havoc in the bond markets, which soon trickles down to the new generation of investors who have bought corporate bond Peps and Isas.

The first market impact of higher rates is on fixed-interest issues. Where an interest yield of 5% looked quite generous against an inflation rate of only around 1% a few months ago, better rates on building society and bank deposits are now inexorably pushing up required returns, at least in line with the bank base rate. It sounds good news - but a rise in yields translates into an automatic fall in the capital value of a gilt, so the existing investor loses out.

Safe as they are thanks to the government guarantee of repayment at due date, gilts are now spurned as long-term investments.

Whereas shares have generally proved hugely rewarding, gilts have generally been disastrous at times of high inflation, although they may be a good speculation when, as now, yields are a good deal higher than the likely future inflation rate.

For example, anyone who sold the Treasury 13.75% 2000-2003 issue near its peak of £113 for every £100 nominal of stock last spring (at the end of a run of interest rate falls) very probably took a good profit on top of the income received from what is the highest interest issue remaining from the runaway inflation era of the 70s.

Now the price has fallen back just below £104. At this level it is a low-risk buy again, providing an income of just over 6% a year allowing for the loss of capital on the final redemption rate just over three years hence.

If the official interest rate kept on rising to 7% or more this would not be so attractive. That still seems unlikely, except perhaps in the strongest economy, the US. Anyway, capital gains, which, unlike the income on gilts, are not subject to tax for UK residents, are the prime attraction for larger private investors.

Consequently, issues with longer to redemption, such as the 5.75% 2009 Treasury issue now back down near the low point of last year at a fraction above the par £100 redemption price are sounder bets. The price was as high as £115 nine months ago, reflecting a wildly optimistic view about the likely trend of inflation and interest rates, though it seemed reasonable at the time. Real interest rates of 4% are very much better than what was available for much of the last century.

Safe yields of 6.5 % are now available on short-dated gilts, dipping to around 5.7% on issues with just over 10 years to run. Long-dated and undated issues appear ridiculously over-priced merely because they are now scarce, while high coupon issues are relatively less favoured because of the loss on redemption.

Seekers of really high yields last year went for fixed-interest and corporate bond issues, often through unit trust offerings. They have had a fairly torrid time over the last nine months as perceptions of the safety of corporate loans, particularly in the US, dimmed.

Losses of around 10% on holdings bought when interest rates were falling are not uncommon. Present conditions are not particularly encouraging even if corporate failures and default on debt are limited by rising prosperity.

Because of the especially high yield that they provide, high yield corporate bond issues became particularly sought after by personal equity plan subscribers. Yields of 8% or more brought strong demand from quite small savers. Advertisements noted that such bonds could entail high risk. But a spread of "junk" bonds could still be quite rewarding, as duds could be offset by a re-rating of winners.

M&G's High Yield Corporate Bond Fund was launched at a low point of the market in September 1998, but along with the others it has been hard put to hold its own over the last nine months. Withdrawal charges might leave a worrying loss, though they reduce over the years. Aberdeen Fixed Interest, an older and still larger fund, applies an initial charge of 4.5% and the normal annual levy. It has the highest running yield of over 8%.

But the capital value has declined steadily over recent months. Convertibles are favoured, but this form of capital is not very common among growth companies.

Many of the corporate loans unit trust managers invested in were mobile communications operators, whose multi-billion expenditure on infrastructure and marketing required high market penetration. So it has proved as the popularity of mobile phones and their use, particularly among the young, exceeds most expectations.

On top of that the takeover of Orange, a leading borrower, and the bid for its German acquirer, Mannesmann, by the UK pioneer and international giant Vodafone, puts the Orange debt up in about the safest category in the private sector.

But while interest rates are rising, cash deposits and some government-guaranteed savings offer complete security and a reasonable income.