Higher interest rates are pushing up bond yields, making it a good time for new investors but less so for existing bondholders, so is now the time to dabble in the debt markets?
Bonds, such as gilts, have taken a battering in recent years due to the low interest rate environment making it a less attractive area for investment.
But investing in debt is becoming more attractive among investors amid the economic uncertainty due to the regular income and higher inflation.
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That’s not such good news if you already invest in bonds though.
Rising interest rates pushing up bond yields for fresh investors but it makes returns on existing debt less attractive, especially as inflation has climbed higher, eating into your returns.
“It’s the best of times and the worst of times to be a bond investor,” says Laith Khalaf, head of investment analysis at AJ Bell.
“Yields are now high enough to feel like a gold rush to fresh investors who have been starved of income since the financial crisis.
“But at the same time rising yields have created heavy losses for existing bond owners.
The 10 year US Treasury Bond yield recently rose above 5% for the first time since 2007, up from 0.6% in 2020, adds Khalaf, while the UK 10 year gilt stands at 4.5%, its highest level since the financial crisis.
“Bond yields have gone back to the noughties, and it’s been a painful transition for bond holders,” says Khalaf.
What are bonds?
Bonds are a debt-based investment and are essentially IOUs. When you buy a bond, you’re effectively loaning money to either the government or a company for a fixed period.
When the fixed term ends, the bonds matures and you are repaid the initial capital plus return. You can also earn an annual fixed rate of interest along the way.
Bonds have an inverse relationship with interest rates; when rates go up, existing bond prices go down. And when interest rates go down, bond prices go up.
That makes old debt less competitive but can make new bond issues more attractive.
“Interest rates are now pushed to a level where you can lock in quite an attractive yield - or income - from your bonds, maybe 5% (which is about the same as you can get from cash,” says Ed Monk, associate director at Fidelity International.
“If interest rates do start to come down, and bond yields follow them down, I think what we will see is the potential for a capital gain as well. As interest rates come down, the price of bonds will go up… so you’re locking in a good income and you’ve got the potential for a capital gain.”
Investors can back bonds individually or through a fund that will build a more diversified portfolio of debt products.
HOW ARE BONDS PRICED
Some bonds are short-dated and mature within five years. They carry less inflation and default risk, but also pay a lower interest (yield/income). Long-dated bonds tend to have a higher interest rate.
It’s worth noting that sometimes the interest on short-dated bonds can be higher than on longer-dated bonds. This tends to happen when central banks are increasing interest rates aggressively and can be an indication of an economic slowdown or recession ahead. This situation is known as an ‘inverted yield curve’.
WHICH TYPE OF BONDS ARE BEST
Like most things when it comes to investing, all bonds are not equal.
Tom Stevenson, investment director at Fidelity Personal Investing, says the balance between risk and reward is firmly skewed towards investing in government bonds as opposed to corporate bonds that are influenced not only by interest rates but also the health of the economy and its impact on companies.
“As the economy slows, more of these may fall into difficulties and become unable to meet their obligations to lenders,” he says.
“This is likely to become a bigger problem as more companies are obliged to refinance their debts at much higher rates.
So-called high yield bonds might look attractive on the basis of the income they offer, he adds, but the risks of failure are commensurately higher.
“Investors who are reaching for the extra income that corporate bonds offer compared with government bonds should err on the side of caution and only invest in the highest quality companies’ debts,” says Stevenson.
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