Bonds should form part of any investor's portfolio. The need to sleep at night is usually the best argument for fixed-interest securities: a 100 per cent equity portfolio might be the right choice for the very long run, but the volatility inherent in stock markets can be damaging to wealth and health.
Even those few investors out there who have a truly long-term horizon would be advised to keep some small portion of their portfolio in bonds.
Some people think that even long-term pension funds would be advised to keep more of their assets in bonds: such investments provide a much better match than equities to the underlying liabilities of the fund.
This was the argument used by the Boots pension fund when it did its high-profile switch to a 100 per cent fixed-interest allocation a few years ago.
For the short-term trader, there are moments when most or all of his money should be in fixed-interest securities or deposits. Whatever type of investor you are, bonds always provide potentially useful information about cyclical developments in the wider economy and can be a helpful aid to sector and stock selection in equity markets.
Bond markets have been confusing the professional investor over the past six months or so. Global economic growth has been strong and is widely forecast to slow only modestly next year. Growth is anathema to bond investors - they cheer when unemployment goes up, for example.
The ultimate destroyer of bond values is inflation and the bond markets are always suspicious of anything that could lead to rising prices. Strong economic growth almost always heralds a rise in inflation, hence the bond markets' aversion to something the rest of us regard as a very good thing.
Commodity prices, particularly oil, have been rising - another traditional sign of inflation in the pipeline. In general, to the extent that we can measure these things, inflation expectations have been nudging upwards.
In equity markets, so-called cyclical sectors and stocks have done well, another traditional indicator that the economic outlook is fine.
Last but not least, government budget deficits around the world are high and, in many cases, still growing, another thing that bond markets hate.
All in all, the things that we traditionally look at to give us a clue about bonds have been almost uniformly negative. This should have been a torrid time for fixed-income investors.
Such is the bond markets' obsession with growth and inflation that many of us look to bond prices and yields as early warning signs of changes to the growth outlook. The bond markets actually have a very good (although far from perfect) track record as economic forecasters. Bad times for bonds usually heralds good news for the economy, and vice versa.
But bond prices have risen strongly everywhere over the past half year. Put another way, bond yields have fallen, as have expectations about the future path of short-term interest rates.
Under normal circumstances, we would take these developments as a sure sign that the global economic outlook is deteriorating: we would have expected equities to struggle (they have done well) and "defensive" sectors and stocks to do well (they have struggled). What is going on?
The standard explanation for all of this is that the traditional links between bond prices, the economic outlook and other asset classes have been broken by the shenanigans going on in the foreign exchange markets.
The huge US current account deficits - which most people think are the reason for the dollar's decline - have to be financed from somewhere. Asian central banks, particularly the Chinese and the Japanese, have been the most willing financiers and the way in which they tend to provide the money is via purchases of US government bonds. The dollars earned by a Chinese exporter to the US end up being sold to the Central Bank of China, which either simply holds them on deposit with a US bank or buys US government bonds.
Such is the enormous and growing size of the US deficits, the acquisition of dollar assets by the Chinese central bank has had to similarly accelerate to avoid upward pressure on the exchange rate.
In a sense, the Chinese government is a forced buyer of US bonds. Whether or not the bonds are intrinsically attractive, they have to buy to keep the Chinese currency stable.
If the links between bond prices and the usual economic fundamentals have been broken in this way, we have an explanation of sorts why US bond prices have risen over the past six months. Prices of 10-year Treasuries, for example, have shot up by nearly 6 per cent - a very big deal in bond market terms and something that should have led to increasing worries over the US economy. If anything, the reverse has happened.
I don't buy the standard explanation. For it to be true, the buying behaviour of Asian central banks should have led to a huge rise in US bond prices relative to other countries. If anything, bond prices in the UK, Germany, France, Canada and Australia have risen by more than their US counterparts.
I think we should take heed of the traditional signals being sent by these falls in bond yields (yields and prices move inversely). I think that there is an important message being sent about the economic outlook that we ignore at our peril.
The right bet to make now in equities is that growth is going to slow by more than the market currently expects. That means lightening up on the equity proportion of our portfolios and moving away from some cyclical sectors, particularly technology.
It is important to place these views in context: I have not become an outright bear of stock markets. I don't think the outlook is that bad. But I simply don't agree with the forecasters who say that 2005, in market terms, is going to be as good as 2004. Anyone who has made some money in stocks this year should think about cashing in some profits.
