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

Despite the Bank of England cutting base rates from a peak of 5.25% in August 2024, the current 4.5% rate is relatively high compared to the 0.5% which prevailed during the Covid era and, indeed, the relatively low rates seen ever since the 2007/8 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, if unspectacular, return. Money market funds provide a diversified portfolio of cash and cash-like investments like short-term loans and high-quality bonds.

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

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 a necessarily a great long-term investment.

That said, longer-dated bonds such as those with maturities over five years can play an effective role in diversifying portfolio risk and typically provide a higher return than short-dated cash. More on the role of bonds later.

Finally, remember that, unlike stocks and shares, bonds do not as a matter of course provide capital growth. Investors get back what they put in plus the interest paid along the way.

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

WHAT ARE MY CHOICES?

Funds in the money market space are predominately actively managed with the objective of beating the benchmark SONIA (sterling overnight indexed average) rate.

SONIA is the average interest rate that banks lend to each other overnight and is used as a reference rate for various financial transactions.

The £750 million Amundi Smart Overnight Return GBP Hedged ETF (CSH2) aims to beat the SONIA benchmark return with low variability. It has an annual charge of 0.1%.

Over one year it has achieved a return of 5.49%, compared with the 5.1% return for SONIA.

A popular money market fund is the £7.5 billion Royal London Short Term Money Market Fund (B8XYYQ8) which has an ongoing charge of 0.1%. Over one year the fund has returned 5.13%.

The BlackRock ICS Sterling Liquid Premier fund (B43FT80) is the big daddy in the space with assets of £45 billion. It targets returns above standard deposits by investing in a broad range of high-quality bonds and money market instruments.

Seasoned managers Matt Clay and Paul Hauff have run the fund since 2009. The fund has returned 5.1% over one year and has an ongoing charge of 0.1% a year.

WHAT ARE GILTS, HOW DO THEY WORK?

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

This section describes what government bonds are and explains the mechanics of how they work.

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 HM 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 a little as a penny.

A gilt is denoted by its coupon and maturity, for example, 1.5% Treasury Gilt 2047. An investor holding £1,000 worth of the gilt will receive two coupon 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 to maturity.

For example, if an investor paid £100 to buy a 3.25% Treasury Gilt 2033 in April 2023 and held to redemption (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 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 last 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 (sometimes referred to as pull to par) made on maturity.

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-dates gilts will fall in price more than short-dates 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 one-and-a-half 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 lower interest rates to stimulate the economy, which is also good for gilts and bonds.

Investors looking for a ready-made diversified exposure to the total UK gilt market might consider the iShares Core UK Gilts ETF (IGLT).

The £3.5 billon fund seeks to track the FTSE Actuaries UK Conventional Gilts All Stocks index and has an ongoing charge of 0.07% a year.

The fund has a weighted average yield to maturity of 4.46% and an average duration of 11.3 years. 

Another alternative is treasury bills or t-bills for short. These are government bonds with a very short time until they mature. Unlike gilts these do not come with income included, your returns is based on the difference between the price at which they are sold and the redemption price, which is in turn heavily influenced by UK base rates. There is no secondary market for these products which have to be held to maturity. Returns from t-bills are taxed as income, however they can be held in an ISA or SIPP to shield them from HMRC. AJ Bell offers three-and six-month t-bills. 

Disclaimer: AJ Bell owns Shares magazine. The author (Martin Gamble) and editor (Tom Sieber) of this article own shares in AJ Bell.

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