How money market funds and gilts can fit in a portfolio

Investors have flocked to money market funds in recent years, attracted by the high rates on offer after the sharp rise in interest rates since 2022.

Despite the Bank of England cutting base rate from a peak of 5.25% in August 2024, the current 4.5% rate is relatively high compared to the 0.5% that prevailed during the Covid-19 era and, indeed, the relatively low rates seen ever since the 2007/08 financial crisis.

Typically, money market funds pay a higher rate of interest than the Bank of England base rate and savings accounts at banks.

This makes them a good instrument to park cash and earn a steady return. Money market funds put their money in cash and cash-like investments, such as short-term loans and high-quality bonds.

Bonds are a type of IOU issued by a government or corporation in return for paying regular interest payments. Income is typically paid semi-annually.

Money market returns in the long term

The downside of investing in money market funds is the relatively low return they offer compared with riskier investments like stocks. It is also important to understand that inflation can seriously erode purchasing power over long periods.

So, while money market funds are great for ‘parking cash’ while deciding where to invest or providing a short-term ‘buffer’ during periods of heightened market volatility, they are not necessarily a great long-term investment.

That said, bonds that have a longer period until they mature, such as those with maturities over five years, can play an effective role in spreading the risk in your investment portfolio and typically provide a higher return than cash.

Money market funds can also be held in an ISA, which means no tax is liable on the income paid.

Funds in the money market space are predominately actively managed with the objective of beating a benchmark dubbed the SONIA, which stands for sterling overnight indexed average rate. This complicated jargon is based on the average interest rate that banks lend to each other overnight and is used as a reference rate for various financial transactions.

What are gilts and how do they work?

While many investors find it easier to stick to investing in bonds through ETFs and managed funds, investment platforms also give investors access to individual UK government bonds.

UK government bonds are sometimes referred to as gilt-edged securities or ‘gilts’ for short. The name originates from the practice putting golden or gilded edges on the paper certificates.

Gilts are a form of debt issued by the Treasury on behalf of the government so it can borrow money from investors.

The price of a conventional gilt is quoted in terms of price per £100 face value, which is also called ‘par’ value. This is the capital value of the gilt at issuance and at maturity. While gilt prices are quoted this way, they can be traded in units as little as a penny.

A gilt is denoted by its interest payment (also known as coupon) and its maturity, for example, 1.5% Treasury Gilt 2047. An investor holding £1,000 worth of the gilt will receive two income payments of £7.50 each on 22 January and 22 July every year until the security matures in 2047.

At maturity an investor would receive a repayment of capital and the final coupon.

Yield to maturity

It is useful to think about gilts in terms of “yield to maturity” because this is the total expected return from buying and holding the gilt until it matures.

For example, if an investor paid £100 to buy a 3.25% Treasury Gilt 2033 in April 2023 and held it to maturity, there would be no capital gain or loss and the yield to maturity would be the annual coupon earned, or 3.25%.

However, if an investor purchased the same bond for £90 and held it to maturity, the investor would make a £10 capital gain in addition to the coupon payments, giving a yield to maturity of 4.53%.

Looking at the other side of the coin, an investor paying £110 would receive a yield to maturity of only 2.11%, including a capital loss of £10.

Gilts are not subject to capital gains

The prospect of treating the return from a gilt as a capital gain rather than income has attracted a lot of investor interest in the past couple of years. The reason is, income from gilts is taxable when held outside an ISA or SIPP but capital gains are tax free.

Many gilts issued before the pandemic had low coupons, reflecting prevailing interest rates at the time.

To generate the same yield as a higher-coupon gilt, a lower-coupon gilt of similar maturity will be sold at a lower price. For example, for a 1% Treasury Gilt 2032 to yield 3.25% in April 2023, it would have to be priced at £82.93.

This means most of the yield to maturity comes from a capital gain.

Sensitivity to changes in interest rates

Longer-dates gilts are more sensitive to changes in interest rates and provide capital gain potential if interest rates fall. The opposite is also true, so longer-dated gilts will fall in price more than short-dated gilts, if rates increase.

A gilt’s sensitivity to interest rates is called its duration. Duration helps investors understand the potential price movement of a bond due to interest rate fluctuations.

The thing to remember is short duration gilts are less sensitive to interest rate changes and long duration gilts are more sensitive.

For example, the price of a 10-year gilt with a duration of seven years would be expected to fall 7% for every 1% increase in interest rates.

In contrast, a short-dated two-year gilt with a duration of 1.5 years would be expected to fall by 1.5%.

Lastly, gilts have the potential to provide ballast to a portfolio of shares during times of market turmoil. That is partly because during such events investors tend to flock to the relative safety of fixed income, driving prices of gilts up and yields down.

If things get bad, central banks tend to step in and cut interest rates to stimulate the economy, which is also good for gilts and bonds.