Updated 23 January 2017
In recent years, bonds have become one of the go-to investments – because they do best when interest rates are at rock bottom, like now. But with so much money tied up in them, this begs the question of what could happen if interest rates begin to rise as predicted. Jonothan McColgan of Combined Financial Strategies advises a cool head and careful advance planning.
The name’s bonds – but what actually are they? Bonds are a class of investment, sitting approximately between cash and equities on the scale of risk versus reward. Essentially what they are is loans, to companies or governments, that are traded on a market (government gilts are also included). You as investor play the role of ‘the bank’, and the bond pays you a fixed rate of income and then repays the original loan value at the end of a specific time period.
Investors increasingly turn to bonds when cash investments deliver poor returns – i.e. during periods of low interest rates. Bond markets have surged lately, as investors seeking income have increasingly moved from bank account holdings up the ladder of investment risk to purchasing bond funds. The 10 largest bond funds now have funds under management of over £50 billion. But market analysts believe that interest rates are likely to rise soon, up to a ‘new norm’ of 2.5 per cent by 2018. What might that do to the bond markets – and to those who currently have money invested in bonds.
When rising interest isn’t so good
With oil prices edging higher, employment figures strengthening and economic growth continuing, Bank of England governor Mark Carney believes the UK economy is almost strong enough to cope with a gradual increase in interest rates, to ward off the spectre of inflation. Although an eventual rate of 2.5 per cent would be good news for savers, the reverse would be true for those with a substantial investment in bonds.
This is because the main risk to bond investments is this: if interest rates increase, there are better returns to be found elsewhere. This makes bonds less attractive, so if you want to sell bonds before maturity, you will be forced to sell for lower and lower amounts to make them attractive for buyers. This risk is called the bond’s ‘duration’, and broadly refers to how much a bond will fall in value as a result of a rise in interest rates (or vice versa).
So what would be the impact of a 2 per cent rise in the Bank of England base rate? Based on current information, it could knock over £4.4billion off the value of the 10 largest bond funds in the UK, creating a fall in value of about 9%.
If you’re used to thinking of bonds as a safer investment than the more turbulent stock market, these projected levels of losses might ring alarm bells. But there’s no need to rush out and sell your bond portfolio just yet. It’s important to realise that, although these bond investments will lose capital value, they will also generate income over this period. Therefore, what you need to do is identify those bond funds that are likely to generate more income over the next two years than capital that they are predicted to lose.
For instance, at the moment both the Invesco Perpetual Monthly Income Plus and Jupiter Strategic Bond funds currently generate running yields of 4.5 percent and 4.2 per cent respectively. These running yields could generate more income over the next two years than they are expected to lose in capital value. They are also both invested in the Sterling Strategic Bond sector, which means that they have a little more investment flexibility than other bond funds that are invested either in the Sterling Corporate Bond or Sterling High Yield.
Other options could be to look at investments that have the flexibility to invest in a wide variety of different assets, such as Multi-Assets funds. However, you need to be careful of the additional risks that these might present.
The end of an era… or not
Government gilts and investment grade corporate bond funds are currently looking most vulnerable to a rise in interest rates, and the current sell-off in the bond market may be only the beginning of the trend. It’s a rude awakening for those who are used to thinking of bonds as one of the lower-risk investment classes. However it is still early days, and there is no guarantee yet that the economy will prove strong enough to sustain such a growth in interest rates. If Mark Carney is forced to hit the brakes again, there could well be a flight back to bonds as a safer option – even if their expected returns are lower. The summary? Keep watch, keep planning, and seek advice.