Why everyone should pay attention to the bond market

Suddenly every newspaper and every broadcaster is talking about the bond market and gilt yields. These terms are often barely understood even by well-informed private savers, but an appreciation of how the bond market works, and how its movements affect every aspect of our financial lives, will make us better investors and better managers of our own money.

Here we’ll explain what is going on with gilts and then outline some of the ways – both good and bad – in which the bond market influences our wealth and everyday finances.

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What is the bond market and what is happening to it?

When governments (and sometimes companies) want to borrow money, they do so by issuing bonds – in effect IOUs that entitle the bondholder to regular payments of interest and, when the bond matures, their original money back. Buyers of bonds (in other words, the people who lend money to these governments and companies) tend to be institutional investors such as fund managers, pension schemes and hedge funds. They constitute the bond market.

These investors trade bonds among themselves all the time, just as shares are bought and sold on the stock market all the time, so bond prices rise and fall continuously while the market is open. This means that the ‘yield’ on bonds also fluctuates continuously. The yield is the annual interest paid by the bond divided by its price. 

As an example, let’s look at a bond issued by the British government that pays interest of 5% a year – in other words, if an investor buys £100 worth of the bonds, he or she will get £5 in interest each year. If, once the bond has started to be traded on the market, its price falls to £90, the yield rises to 5.6% (£5/£90). 

In recent days, the price of these British government bonds (also known as ‘gilts’) has been falling, so their yields have been rising. For instance, a gilt that matures in 10 years’ time yields 4.9% at the time of writing, compared with 3.8% as recently as mid-September. The current yield determines the interest rate the government will have to offer if it wants to issue a new bond (and it has to issue new bonds all the time as existing ones mature). In this case, the government would find no buyers if it tried to issue a new 10-year bond that paid less than 4.9% because investors could get a better return by buying gilts in the market.

Companies’ bonds always yield more than a bond issued by the government of the same maturity, because with companies there is the risk of bankruptcy and the consequent risk that you will not receive your interest or your money back at maturity. So corporate bond yields tend to rise when gilt yields do in order to maintain the gap, so a rise in gilt yields also makes it more expensive for companies to raise money by issuing new bonds.

What are the positive consequences of a rise in bond yields?

1. If you are an income-seeking investor with money to put to work, gilts may now offer an attractive option. Gilts are risk-free if held to maturity in the sense that the government is certain to pay your interest and repay the money you invested when the bonds mature – it first issued gilts in 1694 and since then it has never defaulted on its obligations to bondholders. If you sell before maturity you may make a loss or a profit, depending on market prices when you sell. One strategy is to buy with the intention of holding to maturity but to be prepared to sell opportunistically if prices rise. Gilts can be bought and sold via the government’s Debt Management Office; click here for details.
2. Rising gilt yields drag up the yields on other bonds, such as those issued by companies (‘corporate bonds’). The difference here is that there is the risk of losing your money if the company that issued your bonds goes bust; the extra interest you receive relative to a gilt compensates you for that risk. The risk can also be reduced if you buy a ready-made portfolio of corporate bonds via a bond fund, although bear in mind that if the economy were to enter a severe recession there is an increased risk of widespread company bankruptcies, especially if the bond fund invests in bonds issued by riskier companies, which you can judge by checking the credit ratings of its various bonds (‘A’ ratings are the safest). Fidelity’s Select 50 list of favourite funds, chosen by independent fund analysts, includes 10 bond funds.
3. Another consequence of rising gilt yields is that annuity rates rise. This is because, when you buy an annuity, the company you buy it from typically invests that money in gilts, from which it generates some of the income it pays you in return. 
4. Gilts can be a convenient place to park large sums of money without risk. If you used a bank account, by contrast, your money would be protected only up to the limit of £85,000 by the ‘lifeboat’ fund, the Financial Services Compensation Scheme. While you could spread your money among several banks, this can get administratively tedious. A single gilt purchase provides an alternative; if you want complete security, choose a gilt that matures about the time you expect to need the money.
5. Thanks to a quirk in the tax rules, gilts can also be a good choice for investors who have money to put to work but have already used their ISA and SIPP allowances. The special treatment that gilts enjoy is that any capital gains are tax free, although the interest they pay is taxable. But by careful choice of the gilts to buy you can ensure that almost all of your eventual return comes in the form of capital gain, so your overall tax liability will be very small. Certain gilts, issued after the financial crisis, paid next to no interest because interest rates generally were very low at the time. In order for their yields to be in line with those of other gilts, they have to trade at a discount – that way, the return you might have made from the interest is instead paid as a capital gain when the gilt matures at face value. And that capital gain is tax free.

What are the negative consequences of a rise in bond yields?

1. Anyone who borrows money is liable to suffer when gilt yields rise. Not only the government will pay more to borrow but so too will companies (as we said above, they will have to offer more interest when they issue corporate bonds) and individuals – mortgage rates are influenced by gilt yields. Economic activity can be constrained and house prices could come under pressure, which would be bad not only for property owners but also for banks, which might cut lending as a result, worsening any economic damage. Any sense of crisis over rising gilt yields can exacerbate the situation by hitting sentiment and causing consumers to rein in spending and businesses to defer investment.
2. Existing bond investments suffer because a rise in yields automatically means a fall in price. Anyone who holds an individual bond or gilt can afford to ignore this if they are able to hold to maturity but investors in bond funds cannot do this as there is no maturity date for the fund as a whole.
3. The stock market may also suffer as investors, enticed by the rising returns on offer from bonds, withdraw money from shares in order to buy bonds. Certain sectors of the stock market are likely to come under particular pressure, especially those that tend to yield higher incomes. Those who buy these investments will expect a premium on top of the gilt yield, so they demand a higher dividend yield. This of course means a fall in share prices. Property and infrastructure companies and funds tend to suffer particularly when gilt yields rise. The price of gold and bitcoin may also come under pressure because investors are forgoing more income by holding them instead of bonds.
4. Public services may suffer as more government income is diverted to pay interest on gilts.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of  Fidelity’s advisers or an authorised financial adviser of your choice.