European, UK and US central banks started cutting interest rates in June, August and September 2024, respectively, yet beady-eyed investors will have noticed that 10-year bond yields are higher today than they were then.

The move higher in yields reflects increasing investor nervousness over high government budget deficits, sticky inflation and uncertainty caused by US trade tariffs.

Those concerns have pushed up bond yields on longer dated maturities. So much so that an investor can buy UK 30-year gilts and receive a four-and-a-half-fold return, including the repayment of the original capital, assuming the investment is held for three decades.

In the middle of January 2025, 30-year gilts touched their highest yield since the financial crisis sparked by the Russian debt default in 1998.

Does this represent a great buying opportunity or do higher rates portend something more sinister?  

This article explains why this is happening and explores what higher bond yields could mean for your investments. Later, we also provide some ideas of how to get exposure to bonds directly, and through active and passive funds.

Before getting into the meat of the discussion it may be worth providing some recent historical context.

WHEN NEGATIVE INTEREST RATE BONDS RULED THE ROOST

Five years ago, on the eve of the pandemic, interest rates on government bonds across the western world were yielding close to zero. Investors willing to lend their hard-earned cash to the UK treasury for a decade were offered a miserly 0.2% a year.

At the peak of this apparent madness in 2019, there were around $15 trillion dollars invested in bonds, which, if held to maturity were guaranteed to lose money, according to economists at Deutsche Bank.

That represented approximately a quarter of global bond markets at the time. Sounds crazy, right?

Not at all, claimed bond fund managers, who explained their rationale for holding bonds with implied negative interest rates was that they anticipated them to become even more negative.

We have so far assumed bonds are held to maturity, but they can also be sold and purchased between the time they are issued and maturity. If an investor sells before maturity to another investor who is willing to pay a higher price (accepting a lower yield), a capital gain can be made.

The days of negatively yielding bonds appear to be in the past and according to common wisdom, unlikely to return anytime soon.

BACK TO REALITY

Global supply chain disruptions and shortages coming out of lockdowns and the war in Ukraine ignited inflationary pressures. Central banks were arguably too slow to react, with the US Federal Reserve mistakenly labelling inflation as ‘temporary’.

Subsequently, central banks were forced to increase interest rates aggressively to bring down inflation. For the most part inflation today is getting close to the 2% targeted by the central banks.

Central banks in the US, UK and Europe are all in ‘recalibration mode’ which means they are looking to reduce interest rates, and therefore monetary tightening, as inflationary pressures abate.

December 2024 consumer prices in the UK and the US came in lower than expected, with US core prices, excluding volatile food and energy, rising 3.2% year-on-year compared with expectations of 3.3%.

In the UK core consumer prices rose by 3.2%, down from 3.3% in November 2024. Generally, there appear to be few worries over inflation becoming entrenched.

By most measures, US inflation expectations remain well anchored, hovering around 2.5% for the last two years, having troughed in March 2020 around 1.1%.

As previously mentioned, the recent spike in bond yields has been happening at the longer end of the yield curve. (bonds with longer-dated maturities) Economists refer to this as a term premium.

It means investors are demanding to get paid more for the uncertainty of holding bonds further out on the yield curve.

The worry is that governments continue to finance their budget deficits with more debt. As every student of economics knows, when the supply of something increases, there is a tendency for prices to fall and therefore yields to rise.

WHAT DO HIGHER YIELDS MEAN?

As we started the article off by saying, the good news is that investors can earn a decent level of risk-free return, for the first time in many years.

UK and US government bonds are considered close to a risk-free because governments are unlikely to default on their debts, given their power to raise taxes.

While it is true that higher risk-free rates are good for investors looking for income, risk-free rates play an important role across capital markets, and the effects are not positive for all assets.

For example, higher risk-free rates reduce the theoretical value of riskier assets like stocks and other so-called long duration assets like property and infrastructure.

This effect was evident during the equity market drop of 2022, against the backdrop of increasing interest rates, when technology and other high growth stocks suffered more than value stocks in the market downturn.

Theoretically, stocks are worth the sum of future expected cash flows, discounted at an appropriate interest rate. It is market practice to use the 10-year yield as a proxy for the risk-free rate, sometimes referred to as a hurdle rate.

Think of the hurdle rate as an ‘opportunity cost’ of investing.

To get a flavour of how this works, consider a stream of £100 cash flows each year over the next decade.

An investor can put the cash to good use without any risk, by investing in a 10-year government bond paying 4.5% interest or £4.50. Taking the opportunity cost of £4.50 into account reduces the £100 received in a year’s time to £95.50. It is also referred to as net present value.

This is repeated for every year of cash flow. The important bit to remember is that compounding means the cash flows further into the future are worth a lot less than near-term cash flows.

For example, the discounted value of £100 in year 10 is £64.40 in net present value terms, two thirds lower than year one.

The same effect works in reverse, with stocks getting a theoretical valuation uplift when interest rates fall.

ASSET ALLOCATION SHIFTS

There is another reason why stocks and other long duration assets might fall when interest rates rise. We have already established that the theoretical valuation of equities goes down when interest rates go up.

At the same time, income from government bonds has increased from close to zero a few years ago to 4.5% for 10-year gilts.

Considering long-term total returns from owning stocks in the UK have averaged 8.8% a year since 1899, according to the 2024 Barclays Equity Gilt study, a 4.5% risk-free return represents half of the long-term average return.

Whether yields on 30-year gilts are attractive depends to a large degree on the average rate of inflation over the next 30 years.

Inflation is a very important factor to consider when investing in bonds. Unlike stocks, bonds do not grow, which means inflation can quickly erode the purchasing power of the capital and interest received over the life of a bond.

For example, if UK core inflation were to average the current 3.3% rate over 30-years, the real or inflation adjusted return from a 30-year gilt would be 1.8%, rather than 5.1%. 

If inflation returns to the central bank’s 2% target, the real return will average 3.1%. If, on the other hand, average inflation is higher, investors will probably demand even higher rates, forcing a temporary capital loss on bond holders.

It is important to remember an investor gets their capital back on maturity, assuming the government does not default on its debts.

The Barclays Equity Gilt study shows real returns from gilts since 1899 have averaged 0.9% a year and 2.8% over the last 50 years.

High long-term interest rates have wider economic impacts such as increasing the cost of mortgages and credit which squeezes demand in the economy and potentially reduces consumer spending.

Smaller companies find it harder to gain access to loans and those which carry high or unsustainable debts are more likely to struggle as more cash is soaked up by rising interest costs.

Governments are not immune to the same impact on their cash flows. In conclusion, rising interest rates have many effects on the way financial markets are priced and the real economy.

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THE UPSIDE IS GREATER THAN THE DOWNSIDE

The starting valuation is a critical input to consider when thinking about likely returns, including bonds. With UK gilt yields where they are today, they provide a sizable cushion against a rise in interest rates.

If rates were to fall, income would be enhanced as prices go up and yields move lower. In other words, the upside is greater than the downside. This is referred to as convexity. It means there is an asymmetry in potential bond returns.

In plain English, from today’s starting point, investors stand not to lose much from further rate increases, but potentially gain a lot if rates fall.

BOND MARKETS ARE MULTIFACETED

There are many different types of bonds to choose from including UK government bonds, corporate bonds, overseas government bonds and inflation protected bonds.

There are also niche areas of fixed income such as ABS (asset-backed securities), collateralised loan obligations and AT1s (Additional Tier 1 capital) issued by banks as part of their regulatory capital.

ABS are securities backed by a pool or portfolio of income producing assets such as credit card receivables, auto loans and student loans.

Investing in individual bonds requires a different mindset to investing in stocks and a different skillset and minimum investments in most corporate bond issues are prohibitively high, which is why for most retail investors, investing in bonds via actively managed funds or passive trackers and ETFs is more practical.

For those investors with the confidence to construct their own bond portfolios, most platforms allow retail investors to invest in existing new UK government bond issues which have become popular due to the fact bonds now pay a competitive level of income.

The London Stock Exchange runs the ORB (Order Book for Retail Bonds), giving investors access to government bonds, and corporate bonds issued by household names such as National Grid (NG.) and even mid-cap companies. However, this market hasn’t really taken off and there is pretty limited activity on this platform.

The thing to remember is that different types of bonds have different risks.

Here are some general rules to remember.

Longer dated bonds are more sensitive to changes in interest rates than shorter dated bonds. The same rule applies to low coupons (the annual interest rate paid) which are more interest rate sensitive than high coupon bonds.

Corporate bonds are riskier than government bonds because they have credit risk attached to them. Investment grade bonds are low risk and high-yield bonds are high risk.

Overseas bonds have currency risk which makes them riskier than investing in UK bonds. Inflation is the enemy of all bonds given their fixed income characteristics.

BOND FUNDS

Investors going down the funds route might consider strategic bond funds as a good way to get started. The main advantage of these products is that they can go anywhere and invest in the most attractive parts of the bond markets.

The Artemis Strategic Bond Fund Inc (BJT0KT28:FUND) is managed by a team of three co-portfolio managers and aims to provide income and capital growth over a five-year period. The managers look to preserve capital during tough times and profit when conditions are favourable.

The team position the portfolio around their views on the economic cycle, risk of defaults, yields and interest rates. In the November fund update, the managers said central banks lowering interest rates should be supportive for bonds.

Growing government deficits keeps the team cautious towards longer-dated government bonds while they find the argument for investing in short-dated investment grade bonds ‘compelling’.

The £823 million fund distributes income quarterly and has a trailing yield of 4.7% and ongoing charge of 0.6% a year.

Investors looking to achieve higher yields might consider the Invesco Bond Income Plus (BIPS) trust which aims to provide high income and capital growth from investing in high-yielding fixed income securities.

The vehicle has a market capitalisation of £389.5 million and trades at a slight 1.65% premium to net asset value. The trust has a dividend yield of 6.6%, based on an annual dividend target of 11.5p, paid out quarterly.

The trust has an ongoing charge of 0.94%.

The fund is managed by Rhys Davies who has been part of the Invesco team since 2003 and aided by Edward Craven who became a fund manager in 2020, managing high yield fund and multi-asset funds.

The fund is diversified across multiple countries and industries and invested in high yield bond issued by household names such as Vodafone (VOD) and Aviva (AV.).

The managers conduct expert credit analysis on companies and carefully select investments which they believe off the best risk to reward opportunities. As well as providing a high and predictable income, the dividend has grown by around 3% a year over time.

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HOW YOU CAN USE ETFS TO ACCESS THE BOND MARKET

Investors can use exchange-traded funds to gain exposure to the bond market.

Bond ETFs invest in a portfolio of different bonds giving investors diversification across sectors, maturities and credit ratings.

There are ETFs which track government bonds, corporate bonds issued by public and private companies with different credit ratings, as well as high yield bonds.

One of the main advantages of investing in the bond market through ETFs is that they are low cost compared to actively managed bond funds.

One of the best-performing bond ETFs over the past three years  iShares USD Corporate Bond Interest Rate Hedged UCITS ETF (Acc) (HLQD) has ongoing charges of 0.25%.

Bond ETFs are grouped together by issuer, geography, credit rating, maturity duration and currency.

When buying bond ETFs, it is important to look out for what index the product tracks and exactly what underlying bonds you are exposed to and what the charges are. [SG]

 

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