As interest rates tick up, those seeking an income from their investments may want to look at their options again.
Interest rates have remained at historically low levels for over a decade, with UK base rates below 1% from March 2009 to May 2022. Since then, however, rates have increased four times and stood at 3% at the start of November, with expectations for further rises next year. Interest rates have also been rising in the US and across the Eurozone.
This changing economic environment has had a knock-on impact on fixed-income investments, with yields now rising as a result.
Corporate bonds and gilts are debt issued by companies or the UK government respectively. They generally pay a level income known as a ‘coupon’, over a fixed term, with capital returned at the end of this period. These investments are often seen as less attractive when interest rates rise, as the fixed income paid may be a smaller margin over what investors can get from ‘risk-free’ deposit accounts.
Changing fortunes for bonds and gilts
But we have been living through unusual economic times. Sustained ultra-low interest rates have led to negligible returns on deposit accounts. Demand for bonds and gilts increased significantly, and institutional investors were forced to step up the risk to generate a return on their money.
The increase in buyers for bonds and gilts pushed up market prices — although the fixed income paid remained the same. This has meant that over the past decade the yields on these investments have fallen. For example if you pay £100 for a bond paying £10 a year, this equates to a 10% annual return on your money.
If prices rise to £200 but you get the same £10 then the return is halved. But higher interest rates mean the reverse is now happening. The price of these investments has fallen, boosting yields. For those who already hold bonds, or invest via a fund, this price fall may affect valuations. But lower prices and higher yields can make fixed income a more attractive option, particularly for investors that don’t want the higher risks and volatility of equity markets.
Most retail investors don’t buy individual bonds or gilts but invest via a fund. These funds invest in a broad spread of bonds, so if one defaults its impact should be minimal on overall returns. Some funds will invest in bonds from across the risk spectrum. These funds can be country specific or global.
Others will invest in just one part of the bond market: for example gilts, investment-grade bonds (the highest-rated corporate bonds) or high-yield bonds – issued by companies with a less secure credit rating, which pay a higher income to reflect the higher risk of default. Strategic bond funds don’t have a set allocation to either investment grade or high-yield bonds, but will alter the make-up of the fund as underlying economic conditions change to try to maximise returns and reduce potential defaults.