It is suddenly fashionable to suggest we are in the throes of a fresh investment bubble - this time in government bonds. Gilts have been bid up to dizzy levels as investors buy into the notion that deflation is coming and is here to stay. Why else buy assets yielding only 1 or 2 per cent unless you believe that Britain is heading into a Japanese-style lost decade of ultra-low interest rates and relentlessly falling prices?

John Redwood, the former Welsh Secretary, who these days supplements his backbench stipend as a City money manager, joined the sceptics yesterday, saying that only the greater fool theory explained the enthusiasm for the asset class.

Alistair Darling, however, will be hoping desperately that the passion lasts. He is set to tap bondholders for a record £146 billion this year as the Government embarks on its huge borrowing spree. He needs the keenest possible investor appetite.

Certainly, the trends have been favourable. Pension funds continue to dump equities in favour of gilts. Banks may be forced into vast acquisitions of gilts very soon in order to meet new liquidity rules. The authorities may soon snap up gilts as part of a policy of “quantitative easing”.

The deflation story - the narrative that underpins it all - shows little sign of crumbling. Policies thus far seem to have done little to brake the West's economic freefall.

Bubble it may well be, but that does not mean that it cannot inflate further. Ultimately it will burst, however. Governments can and will engineer a return of inflation. The moment that there is a hint of interest rates having to rise, the reversal could be swift. Bond investing old-timers still recall the burnt fingers of 1994, another rapid turning point for inflation expectations and monetary policy.

Mr Redwood suggests that investors sell government bonds and buy good-quality corporate bonds. Here there are much more enticing interest rates on offer. Bonds issued by Marks & Spencer yield 8 per cent at present, National Grid 7.25 per cent and Vodafone 5.75 per cent. For small investors, there are plenty of high-quality corporate bond funds on offer.

And at this point in the cycle, company bonds should bounce before the corresponding equities.

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