Bonds – A busy year, but not in a good way!
It has been a turbulent year for bond investors to say the least! Everything seems to have come at them at once, including soaring inflation and central bank action to raise rates; a war in Ukraine; and political uncertainty in the UK and elsewhere. To summarise:-
- The yield on a 10-year UK government bond, or gilt, fall by 0.09 per cent to 1.83 per cent in Sept
- $8bn (£6.63bn) wiped off the value of UK corporate bonds since the start of 2022 to 31 June. This will be even larger since the August interest rate rise
- £283.8bn wiped off the value of gilts over H1, according to digital asset manager Collidr
As a result, we are seeing unusually high levels of losses in the fixed interest market, for an asset class that would typically be described as ‘cautious’.
So why is this happening?
With central banks embarking on base rate rises to combat eye-watering inflation, we never get a ‘win:win’ scenario in economics. As such, there are always winners and losers – with every reaction, there is a counter reaction. And this can be said for rising interest rates.
To understand why bond prices have crashed, we must first look at why interest rates have risen so sharply in such a short space of time.
Typically, inflation and interest rates are interlinked, sensitive to each other’s movement. This is most part due to Monetary Policy. Soaring inflation can cause huge problems and this has been no more evident than in the ‘Cost of Living Crisis’ that we are experiencing this year. Things can get too expensive! To try and combat the demand for goods and therefore hoping to bring prices down, the Monetary Policy Committee and the BOE look to raise interest rates to effectively squeeze our purse strings! If we are spending more on debt interest, then we have less to spend elsewhere. This in turn brings down demand, and the theory is that this will then reduce inflation.
So what has been the problem this year? The issue has been time! Changes in interest rates have occurred for decades, but typically these would be incremental, and adapted over a longer stretch of time. By contrast, we have had a 2% rise over 7 stages, it just under 9 months!
The current rate of interest is 2.25%, and over a 45 year period of rates, this is still statistically very low. Before the economic crash in 2008, rates were 5.75%. 10 years prior, there were even higher at 7.50%, and in 1981 they were an eye watering 15%!!!!!!!! So the rate rise isn’t the main issue here – its the short time it’s taken for the rise to happen thats the problem.
So why are bonds affecting by interest rates?
Bonds and interest rates have an inverse relation – when one goes up, the other goes down! But why is this the case?
A bond is an asset used by the government and corporate entities to raise money. It’s essentially a loan; they offer a fixed return over a set period of time, in exchange for your money! For example, Tesco may issue a bond for £100, and offer you 5%pa over 5 years. In exchange you can give them your money, and you receive your £5 coupon each year for 5 years. But we then get a bit more complicated – the bond issuer wants their investment to remain competitive for new investors. At the time of issuing the bond, interest rates may have been 1% therefore Tesco’s 5% seemed a great return. However, if interest rates rise, a fixed interest bond is far less competitive. Who is willing to risk their money with Tesco for 5%pa, when their bank will give them 4% on their savings account.
To combat rate risers, bond issuers and market demand reduces the purchase/sale value of the bond to reflect higher interest rates. The Tesco bond that Mr Smith bought for £100, is now £80. The lower price subsequently increases the yield; that £5 return now equates to 6.25%pa. We typically find a 1% movement in interest rates can shift bond prices by around 10%.
To summarise, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price to offset this. In particular, longer dated bonds are extremely sensitive to rate rises due to their lack of liquidity.
Frances Giliker LLB Hons APFS
Chartered Wealth Planner and Director