Once issued, a bond will trade on the financial markets. Their prices can therefore rise and fall, driven heavily by expectations for inflation and interest rates, as well as investor confidence in the issuer. Yields on these will move in the opposite direction to prices: when prices fall, yields rise.
That is why recent movements in government bond markets matter. Yields have risen sharply across much of the world, reflecting concerns about the scale of government borrowing in many countries (US national debt recently passed $40 trillion) and persistent inflationary pressures from high oil prices as the US-Iran conflict remains unresolved. Another factor is greater competition as major technology ‘hyper-scalers’ are raising debt to finance the construction of data centres and other AI infrastructure.
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UK government bonds, known as gilts, have been at the forefront of rising yields. Gilts due to mature in 10 years are currently yielding around 5.3% – the highest level since 2007 – and are the highest among the G7 major developed market economies. The UK is seen as particularly exposed to higher energy prices, and investors are also waiting to see how the new Chancellor, John Healey, will address the challenges facing the public finances in his first Budget on October 28.
Higher yields are undoubtedly a headache for the Chancellor. They increase the cost of borrowing new money and refinancing debt as existing gilts mature. The more money spent servicing debt, the less available for public services. The Chancellor will face difficult choices on public spending and tax as he seeks to navigate this constrained environment.
However, every cloud has a silver lining. What is unwelcome for governments can create opportunities for private investors.
For many years, bonds offered very little income. Following the global financial crisis in 2008, and particularly during the period of ultra-low interest rates that it triggered, investors were often forced to accept meagre yields from bonds, driving them towards equities instead. That has now changed and to some extent bond yields are now returning to historically more normal levels.
Cautious investors and those seeking income can once again find reasonable returns in bond markets, providing a useful alternative to holding large amounts of cash or relying heavily on volatile shares. For example, the dividend yield on the FTSE 100 is currently around 3%, below the yields available in the bond market.
This does not mean investors should abandon equities. Shares remain our preferred asset class over the medium to long-term because of their potential for both capital growth and rising dividends. But portfolios should rarely be built around a single asset class, and bonds provide diversification and a valuable source of income alongside equities.
Investors can gain exposure through funds focused on different areas of the bond market. These include government bonds, investment-grade corporate bonds issued by financially robust companies, and higher-yielding bonds from businesses with weaker credit ratings. Short-dated bond funds – those investing in bonds that will mature within the next five years – can be less volatile than those investing in longer-term debt, as their prices are less sensitive to changes in interest rate expectations.
Strategic bond funds offer a more flexible approach, allowing managers to move between government, corporate, investment-grade and higher-yielding bonds according to where they see the best opportunities. For investors wanting a diversified, one-stop approach, this can be a good option.
For those with large cash savings outside of tax-wrappers such as ISAs and pensions, there can also be advantages in directly holding gilts rather than through a fund. Many of the gilts already in issue can currently be bought for prices less than the amount they will repay at maturity. Much of the eventual return will therefore come from a price uplift rather than the coupon income. A key point here is that for UK private investors, price gains on gilts are exempt from capital gains tax. This means that while the interest from the coupon may be subject to income tax, if most of the return will come from a capital gain the overall return after tax can be much more attractive than even best cash savings accounts – especially for people subject to the higher, advanced and top rates of tax.
Investing in gilts is however not akin to a saving account. Their prices could fall further if yields continue to climb and you find you need to sell before they mature. They are not suited for someone looking for instant access, but they do offer predictable returns if held to maturity. Higher gilt yields are also good news for retirees considering buying an annuity. Annuities provide a guaranteed income for life in exchange for some or all of a pension pot, and changes in their rates are closely linked to movements in gilt yields.
A healthy 65-year-old buying a single-life annuity with a five-year guarantee can currently secure just over £8,000 a year from a £100,000 pension pot. That compares with well below £5,000 at the market lows of a decade ago, when gilt yields were exceptionally low.
Annuities aren’t for everyone: they can be inflexible, and the income may not rise with inflation unless an inflation-linked option is selected, which means accepting a much lower starting income for the same annuity price. But for retirees prioritising greater certainty over investment flexibility, today’s higher rates deserve serious consideration.
In summary, rising bond yields are unwelcome news for the Treasury, particularly ahead of a Budget. For investors and retirees, though, they represent opportunities.
Jason Hollands is a managing director at wealth manager Evelyn Partners, part of NatWest Group, which has offices in Glasgow, Edinburgh and Aberdeen