If you picked up a newspaper in the last few weeks you probably read about the mini-meltdown in the bond market. Gilt yields, which move in the opposite direction to prices, started to rise all of a sudden, and it looked like things might spiral out of control.

These yields dictate the rate of interest the UK government pays to borrow money, which is one of the reason they are so important. As it happened, the panic dissipated as quickly as it appeared, and gilt yields are back to where they were at the beginning of the year, at the time of writing at least.

However, government bond yields are still much higher than they were just a few months ago, both here and in the US, as the chart below shows. Lots of people seem to think the rise in gilt yields is Rachel Reeves’ fault, but that doesn’t really explain why US bond yields have been rising too. Nonetheless these higher yields could have knock on consequences for the chancellor if they are sustained, and they will also have an impact on savers and investors.

HIGHER RATE EXPECTATIONS

Higher gilt yields are partly driven by expectations that interest rates will stay higher for longer, and that same factor has led to mortgage rates picking up again. The typical two-year fixed mortgage (with a 75% Loan to Value) rose from 4.4% at the end of October to 4.6% at the end of December, according to data from the Bank of England. The comparable five-year rate has risen from 4.1% to 4.4% over the same period. These are relatively small moves compared to the big hikes in mortgage rates we saw in 2022, but nonetheless they might sting a bit seeing as the Bank of England is actually cutting interest rates.

In theory higher interest rate expectations should feed through into higher cash rates too. It might not come as the greatest shock in the world to learn there’s little evidence of this feeding through yet. Banks tend to be slower to pass higher interest rates on to savers than they do to borrowers, for fairly obvious reasons. It may be that we see savings rates pick up a bit in February. There are normally at least a few providers who try to drum up some business by creeping up the best buy tables, especially as we approach the end of the tax year. But much of the banking sector may simply hold their current course on savings rates, unless there is a more significant lurch upwards in yields more broadly. And with an interest rate cut expected from the Bank of England in February, we could even see some rates drifting back down again.

HIGHER YIELDS FROM BONDS

Bonds themselves are now offering a higher yield too. Many investors access bonds through bond funds, which can invest in government and corporate bonds, or a mixture of the two. If held in an ISA or pension, the income produced by these funds is tax-free. Investors can also buy individual gilts, which also produce a tax-free income if held in an ISA or SIPP.

However, some gilts may also produce a largely tax-free return if held outside a tax shelter too. That’s because some ‘low coupon’ gilts pay very little income, and so most of the return comes from price appreciation.

Unlike shares, gilts are exempt from capital gains tax, so returns from rising prices can be harvested free from tax. In the last year or so we have seen some investors using these low coupon gilts as a cash proxy, to tap into the attractive tax treatment and keep more of their returns out of the clutches of the taxman.

Pensions, in particular annuities, are also impacted by higher bond yields. For the uninitiated, annuities are an insurance contract, essentially offering a secure income for life in exchange for a capital sum from your pension. They used to be widely used, before 2015 when George Osborne introduced legislation which opened up other options for drawing your pension, known as the pension freedoms. Nowadays around one in 10 pension savers end up buying an annuity. Those about to take the plunge will have cause to rejoice as rates have been creeping up in response to higher bond yields.

TAKES TIME TO FEED INTO ANNUITY RATES

Annuity rates tend to respond relatively slowly to bond market movements, so there may even be some more increases in the post. Annuities can be part of a retirement plan because they provide a secure income for life, and are certainly worth considering. One reason they’re so unpopular though is they are pretty inflexible, and the majority of pension savers now choose to keep greater control of their retirement funds.

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