Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Bonds show it’s no time to buy
While all eyes have been on the fuel crisis, little attention has so far been paid to the impact of higher oil and gas prices on government bond yields.
The yield on the benchmark UK government bond has been rising steadily, and now sits at over 1.1%. To those who remember gilt yields of 5% and higher prior to the financial crisis, 1.1% sounds very low. Historically, it is.
But only two months ago, the yield stood at just 0.5%, and if it rises further it could be extremely damaging for bond investors.
UNDERSTANDING GOVERNMENT BONDS
A gilt is simply a UK government bond; it’s an IOU promised by the Treasury when they borrow money, something they’ve been doing a lot of recently.
The yield on these bonds rise when prices fall, so the recent increase from 0.5% to 1.1% shows investors have been selling out of gilts. That’s because the spiralling price of oil and gas has heightened concerns that inflation may be more severe and long lasting than the Bank of England has suggested.
Inflation is very bad for bonds, because the value of the fixed income stream they pay is eroded by rising prices.
The 10-year gilt yield is still below the central bank’s 2% CPI inflation target, however, so bond investors are clearly still willing to accept a return below the rate of inflation, even assuming the Bank of England has it under control.
That’s because interest rates are still very low, and the Bank of England is still committed to its quantitative easing programme in which it holds £875 billion of government bonds.
However, a recovering economy and rising inflation heaps pressure on central banks to scale back QE, and raise interest rates. November looks like it could be a crunch month as central banks on both sides of the Atlantic will meet to determine whether it’s time to tighten monetary policy.
WHAT RATE RISES MEAN FOR FIXED INCOME
Conventional gilts would not fare well if interest rates rise. So far this year, UK gilt funds have on average fallen in value by 7%. While that’s probably not enough to make most equity investors blush, investors choose bonds because they’re seen as safe havens.
This may prove to be a false sense of security for gilt investors though, if we really are entering a new era of interest rate hikes. The last 12 years of ultra-loose monetary policy has driven gilt prices so high, they now carry an awful lot of valuation risk, and offer a pretty measly yield in return.
Other bonds take their lead from the government bond markets, but they won’t all be affected to the same extent. Unlike gilts, corporate bonds (both high quality and riskier high yield) carry a higher interest rate, which cushions the impact of price falls emanating from tightening monetary policy.
They also tend to be shorter dated, which means they are less sensitive to interest rate rises. Being loans to companies rather than governments, they also experience some upward pressure on prices from an improving economy, because the accompanying earnings growth should make it easier for companies to service their debt.
In a rising interest rate scenario, ‘riskier’ bond funds should fare better than ‘safer’ conventional gilt funds, though they still might not make a positive return.
STRATEGIC BOND FUNDS: A USEFUL TOOL
Strategic bonds funds can be useful tools for fixed income investors. These have the flexibility to invest in global government bonds, high quality corporate bonds, and high yield bonds across the globe, giving the fund manager the scope to pick up a higher income where they can, and potentially protect investors from tightening monetary policy in certain countries.
Index-linked gilts also offer investors some protection from inflationary pressures because their capital and income rises with RPI. However, they also tend to be long-dated, which means interest rate rises will take some toll on that uplift.
Rising interest rates pose a challenge for all bonds. But of course, tighter monetary policy isn’t a given. If the economy takes a dive, central banks may simply maintain low interest rates and QE, or even possibly loosen monetary policy. In that scenario, bonds will do quite nicely, and in a portfolio will provide a hedge against falling equity markets.
If the last 12 years have taught us anything, it’s that we shouldn’t rule out the possibility that interest rates can be cut further, as inconceivable as that has seemed at times. But rates are now so low, there’s just not much more room for them to fall, while there’s plenty of scope for them to rise.
The balance of potential gains and losses therefore suggests parts of the bond market are best avoided, and others should be bought selectively.