FEW investors took up their ISA entitlement last year, and fewer still are expected to do so this year.

This could be a mistake. Personal taxes are rising, and interest rates are low and likely to go even lower. A capital and income tax-free home for savings should not be ignored, especially since ISAs can be used to shelter the stable and safe income available from government bonds - or gilts. This is particularly so in a world where investment returns are likely to be much less than anticipated compared to what investors expected when planning for their retirement.

An extraordinary development took place in the 1950's - investors began to prefer to own shares even when the annual dividend income they earned was less than that available from government bonds. Many of the older market professionals found this reverse-yield gap unnatural. The profits - and therefore the dividend income - of even the biggest and best companies is uncertain, while the income from gilts is both safe and certain.

But the younger investment managers realised that the world had changed in two significant ways. The first was that the victorious Americans were determined that their allies would adopt the consumer society. This would not only immunise Europe from the worst excesses of nationalism, but also keep it safe from communism. For the investor, it would ensure a growing demand for the output of business, and so make industry less subject to the devastating swings of the business cycle.

These younger fund managers appreciated that markets change as politics and circumstances alter. The successful investor is the one that can guess what changes are happening - or might happen - and catch the tide as it turns.

During the decade after the 1929 crash, shares produced only modest returns compared to the average, but gilts did very much better.

After the share boom in 1959, equities continued to do well, if at a lower rate, but gilts did very badly indeed. The two decades after 1980 saw share returns double their long-term average, with the freedom of revised foreign exchange controls and the reduction in trade union influence. But gilts also did well, as taxes on investment income were reduced.

The legendary American investment guru Warren Buffett has said that, while in the short-term the securities market is a betting machine, in the long-term it is a weighing machine. So investors who held bonds (gilts) over 20 years not only did at least as well as those who held shares only, but took much less risk for the same reward.

Those investors have kept more of their wealth as share prices slumped. This is not only because bond prices are less volatile than those of shares, but also because the income earned was much higher. Market price movements are important to portfolio valuations over one or two years, but over five or ten it is the compounding of the income generated in a portfolio that really produces the capital gains.

The general problem with ISAs is that their costs, when added to those of a unit trust, destroy most if not all of the tax advantages granted. This is even truer of bond funds with their fixed income returns. Fortunately, investment in gilts is simple and needs little expertise.

To maximise the benefits available a "gilt ladder" should be created with repayment dates running from ten to 30 years in the future. Concentration should be on the running yield - market price divided by interest rate on the bond - since all the return is tax free.

Alternative low-cost methods of investing in bonds are to be launched later this year and these are expected to have minimal annual management charges with no front-end charges. With the economic outlook still volatile, this is not the time for any but the best quality investment-grade bonds, with yields around 6.5 per cent and offering modest growth.

Such returns may seem low to those accustomed to the double digit returns of 1980s and 1990s, however current trends suggest the next few years are unlikely to produce equity returns above the last century average of 5.8 per cent per annum.

* Trevor Kirkley is principal of Redworth Caledonian Associates, Independent Financial Advisers, Bishop Auckland, and can be contacted on 01388 607722.

Trevor Kirkley is principle of Redworth Caledonian Associates, Independent Financial Advisers, Bishop Auckland, and can be contacted on 01388 607722.

Published: 23/09/2003