As interest rates have risen over the last two years, cash products have grown in popularity, especially Cash ISAs which allow you to receive your interest tax-free. But it’s actually perfectly possible to benefit from higher interest rates within a Stocks and Shares ISA too, as it’s not just cash accounts at the bank which pay interest.

As with a Cash ISA, your interest in a Stocks and Shares ISA is protected from income tax, so you don’t have to hand over any of the return your money is generating to the taxman. Here are some of the investments available within a Stocks and Shares ISA which are now enjoying better returns because of higher interest rates.

Money market funds

Money market funds saw rising demand from Stocks and Shares ISA investors in 2023. These are funds which invest in cash-like instruments, predominantly short term deposits with banks, and short-term loans to governments, banks and large companies. Some of these loans take place for as short a period as overnight. Money market funds typically have very low levels of volatility, which makes them an appropriate choice for more cautious investors.

Investors probably picked these funds in 2023 because they are low risk yet were offering very respectable yields as interest rates rose, in sharp contrast to the prior decade. The chart below shows the return from the average money market fund last year was 4.66%, though past performance is no guarantee of future returns. The yields offered by these funds are variable, and depend on short term interest rates, but clearly these are now much higher than they were in the 2010s.

Bond funds

Bonds are basically an IOU, whereby investors lend money to governments and companies in exchange for a set rate of interest with capital to be repaid at a set date in the future. For many years the rate of interest paid by bonds was uninspiring, causing some to describe government bonds as ‘return-free risk’. But that’s all changed. Since interest rates have risen, it’s now possible to pick up pretty appealing yields from bond funds.

Bond funds can and do fluctuate in value, and if interest rate expectations rise, you can expect to see bond prices fall. Clearly fluctuations in valuation does mean there is some risk, but bonds can actually lower the volatility of your portfolio as a whole if you are also holding shares. That’s because bonds, especially government bonds, tend to move in the opposite direction to share prices, so if you hold both in your portfolio, you should get a smoother ride.

Individual gilts and corporate bonds

Investors can also buy individual government bonds and corporate bonds instead of a bond fund if they wish. Last year at AJ Bell we saw an uptick in the number of investors using individual gilts to park large sums of money and lock into higher interest rates, presumably as an alternative to moving into cash.

Gilts are loans to the UK government, and it’s pretty certain you will get your loan repaid, along with the interest promised, as there’s a very, very low chance of the UK Exchequer defaulting on its debt obligations. 

This is probably why investors with large sums of money have been using them, as bank deposits are only covered by the Financial Services Compensation Scheme up to a maximum of £85,000 if their bank goes bust. Corporate bonds are considered less safe because they are loans to companies, which are deemed more likely to default on their obligations than, for instance, the UK government.

The price of bonds fluctuates on the market, but there will be a maturity date for each bond, at which point you will get the maturity value of the bond back, unless there is a default. The maturity value, also called the par value, may be more or less than you paid for it, depending on the price you bought in at.

Many bonds are currently trading at below their par value, in which case the return you can expect back between now and maturity is a combination of interest payments and capital gains. Individual bonds can be a bit tricky to get your head around, so this approach is probably best left to more experienced investors or those who are willing to roll up their sleeves and delve into the nitty gritty.

Multi-asset funds

Multi-asset funds are another potential beneficiary of higher interest rates. These funds invest across a range of assets including shares, property, commodities, bonds and cash. These last two asset classes are now offering much higher interest rates, which will be a boost to the fund managers running these funds.

Multi-asset funds come in a range of risk profiles to suit investors with different appetites for volatility, so the amount of exposure you can get to bonds and cash ranges from very low to very high. These funds are useful for investors who want a mix of assets in their portfolio but want a professional fund manager to pick and choose what to invest in.

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