The Bank of England has hiked interest rates to 3% this year, as it attempts to control rampant inflation in the economy. It also looks as if the central bank is going to raise rates again when it meets on 15 December.
In general, higher interest rates mean that borrowing money becomes more expensive, which can discourage borrowing and spending, but they also make it more attractive to save money.
In fact, we’re seeing interest rates on savings accounts return to levels not seen since before the financial crisis as banks fight over our business.
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Interest rates on bonds are also on the up, which is good news for investors who’ve been starved of income over the past decade.
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Why now could be the time to buy bonds
Interest rates and bond prices have an inverse relationship, meaning that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
This relationship exists because when interest rates increase, new bonds are issued at higher interest rates (commonly referred to as the bond yield), making existing bonds with lower interest rates less valuable. As a result, investors will be willing to pay a lower price for existing bonds with lower interest rates, causing their prices to fall.
Conversely, when interest rates decrease, new bonds are issued at lower interest rates, making existing bonds with higher interest rates more valuable. As a result, investors will be willing to pay a higher price for existing bonds with higher interest rates, causing their prices to rise.
Other factors also influence bond prices. According to Matthew Roche, Associate Investment Director at Killik & Co, “Sentiment is also a major driver of market movement.”
“When investors become more risk averse, they tend to demand higher returns from all assets, including bonds and gilts,” he says.
What are Gilts?
Gilts are bonds issued by the UK government. The term "gilt" refers to the fact that the bonds were originally issued with a gilt edge, meaning that the edges of the bond certificates were finished with a thin layer of gold.
Gilts are considered to be among the safest investments because they are backed by the full faith and credit of the UK government, which is considered to be highly creditworthy.
In September, the mini-budget triggered a huge sell-off of Gilts and yields (the interest rates paid on the bonds) surged.
As Roche points out, yields on 30-year Gilts “rose to a peak of 4.99% from just 1.1% at the beginning of the year.” While the market has since calmed down, yields remain elevated.
Investors can buy a 30-year Gilt today with an interest rate of 3.4%. That’s a lot better than the rate on most savings accounts - especially if you’ve got a large lump sum to invest.
Is it time to buy Gilts?
So, could this be a good time to buy Gilts for income?
“Currently, the bond yields on offer are proving tempting for many investors, particularly in comparison to holding cash, the value of which is still being eroded by inflation despite higher returns,” Roche notes.
With the risk of a recession also growing, bonds could be a “safe bet” for investors seeking income in times of uncertainty.
For many, high quality bonds could represent a good value source of income, especially if stock market investors are hit by recession as we’d expect – in times of financial crisis, many revert to buying bonds as a so-called ‘safe bet’.
“Furthermore, bonds can be held in tax wrappers, such as ISAs and SIPPs,” Roche notes and “Even when held outside tax wrappers, most bonds are not liable for Capital Gains Tax,” he adds.
These tax advantages could be significant for investors, especially when “bonds are purchased below the redemption price paid to the holder on the maturity of the bond.”
It could be time to buy bonds, but there are risks
Still, as is the case with any investment, there are still risks.
“Despite the relative return to calm, in the medium term, there is likely to be continuing volatility linked to market expectations of inflation and interest rate movement, and a related risk premium remains,” Roche notes.
What’s more, there’s a “dizzying array of corporate and government bonds with a range of names, maturities and coupon prices,” so it’s important investors know what they’re buying before getting involved with any particular security.
There are some other benefits of higher bond yields, which are also worth considering. “They will, in turn, boost yields elsewhere, such as annuities. That is potentially good news for savers and retirees, for example,” Roche summarises.
