Bonds, including gilts, are now offering yields that could be worth considering again as a component of  investment portfolios. This development presents a good opportunity to refresh your understanding of bonds and why they can be useful to have in a portfolio. Read on for answers from our expert market commentator Jason Hollands including:

• How rising interest rates impact the bond market
• What are bonds? and How are bonds assessed? 
• Are corporate bonds a risky investment? and How to invest?
• Fund factsheets – what to consider

How rising interest rates impact the bond market

In the past, bonds were typically a significant part of investors' portfolios, providing a combination of steady income and the benefit of diversification to help temper the volatility that comes with investing in equities. However, since the global financial crisis of 2008 ushered in an era of ultra-low interest rates, many investors have ignored bonds entirely.

Since then, the yields available on bonds have been incredibly low, reflecting the backdrop of historically low interest rates and periodic bond-buying stimulus programmes by the Bank of England and other central banks to keep borrowing costs down and support the financial system.

As a result, a generation of investors’ attention has focused on the equity markets. Indeed, until very recently, the dividend yield on the UK equity market has been higher than the yield on 10-year gilts. 
 
However, as a result of the most aggressive cycle of interest rate rises in decades, we are now in a vastly different environment from the one that investors have been used to since the global financial crisis.

What are bonds? 

Bonds are also referred to as ’fixed interest’ or ’fixed income’ securities. They’re essentially ’IOU’ notes issued by borrowers such as governments and companies who want to borrow money from investors, usually for a fixed period.

The big investors in the bond markets are insurance companies and pension funds, who are looking for predictable returns. However, bonds – and funds investing in portfolios of bonds – can also be useful part of an individual investor’s portfolio, alongside equities and other asset classes. 

When a bond is issued it will provide investors with a regular, fixed amount of interest (known as the coupon) until the issuer of the bond repays the loan to investors at the stated maturity date. Bonds can be issued across a range of time periods until they mature and are due to pay back investors, such as five, ten, fifteen or even thirty years or more.  

Once issued, most bonds are traded on a secondary market, such as the London Stock Exchange. The value of those bonds could rise and fall compared to the value at which they were first issued, and the value at which they will be repaid (known as the ‘par value’).

Bond prices are driven by a combination of

• Changes in inflation and interest rate expectations
• Economic climate
• Outlook for the bond issuer
• Investor demand

As a more predictable type of investment than equities, investors often gravitate towards bonds, and government bonds in particular, in times of economic uncertainty. 

How are bonds assessed?

There are many distinct types of bonds, but the two key categories are:

1. Government or ‘sovereign’ bonds. These are issued by governments to finance public spending
2. Corporate bonds, which are issued by businesses

A key consideration when assessing bonds is how financially robust the issuer is and how likely they will be able to meet both the expected interest (coupon) payments on time, and eventually repay the loan at the stated maturity date.

Failure to do either of these is known as a ‘default’.  

What is a government bond?

Bonds issued by the UK government are known as 'Gilts' or 'Gilt-Edged Securities' to reflect their perceived high quality. Bonds issued by governments of major economies with stable political systems are seen as extremely low risk, with little chance of defaulting on their obligations. 

Some governments have however defaulted on their bonds in the past, such as Russia in 1998, Greece in 2012 and Argentina in 2020. Bonds issued by emerging market nations – referred to as Emerging Market Debt – are considered riskier than those issued by developed market countries.

What are corporate bonds?

Corporate bonds are riskier than developed market government bonds and will typically pay a higher level of interest compared to the government bonds in the main market where they operate.

However, this will depend on how financially robust the business issuing the bond is. Credit rating agencies such as Fitch, Moody’s and Standard & Poor’s provide ratings of bond issues, with high quality issuers being rated as ‘investment grade’ but lower quality issues being classified as ‘High Yield Bonds’.  

Are corporate bonds a risky investment?

Bonds issued by companies with weaker ratings, where there is a greater risk of a default – such as the potential to miss interest payments or be unable to repay the loan in full and on time – need to pay higher rates of interest to reflect these risks and attract investors.

With the risk of recession on the horizon, defaults from High Yield Bonds are likely to rise, so cautious investors should be wary about investing in this part of the bond market. Try not to get dazzled by the very high yields available.  

Alongside the credit quality of the issuer, the length of time until a bond is repaid is another factor to consider. Longer-dated bonds are more sensitive to changing expectations and swings in value compared to those due to mature soon. Shorter-dated bonds could be less risky.

Understanding bond yields 

While the rate of interest (the coupon) on a bond is typically fixed at the time it is first issued, as the price of bond moves up or down on the secondary market, this will impact the annualised return a new investor buying a bond will receive if they hold on to it until it is redeemed.  
 
The combination of the fixed amount of interest an investor will receive and any gain (or loss) on the price they paid for the bond when it matures, together make up an annualised rate of return known as the ‘Yield to Maturity’.

Unlike the current interest rate on a cash savings account, which could rise or fall over the coming months and years, when you buy a bond the Yield to Maturity is a return that a buyer is effectively able to lock in, as the coupon on the bond is fixed and the investor knows the value that the bond will eventually be redeemed at (providing the issuer doesn’t default), and whether this creates the opportunity for a capital gain or loss. 

Gilt yields have risen significantly since the Bank of England began raising interest rates in December 2021. They have not been at such elevated levels as they have been in recent months since 2008, which has sparked the interest of an increasing number of investors. Gilt yields move around, but you can check the latest 10-year gilt yield – a widely used benchmark – here. Don't forget that when you invest in gilts and other bonds, there will either be fund costs or, in the cast of direct purchase, there will be dealing costs.

How to invest?

While it is possible to invest directly in individual Gilts and other bond issues, many online platforms, including Bestinvest, do not facilitate trading directly in them. An alternative route is to invest through a diversified government bond fund, or a fund that blends both government bonds and corporate bonds. 

For example, two funds in the UK Gilt sector that are on the Best Funds List are the Vanguard UK Government Bond Index fund and iShares Core UK Gilts UCITs ETF, both of which invest in Gilts that mature over a wide range of timescales. iShares also have an exchange traded fund, the iShares UK Gilts 0-5 Years UCITS ETF, which focuses on Gilts due to mature within the next five years. You can check the current yields on 5-year gilts here.

Examples of funds on the Best Funds List that are focused primarily on investment grade corporate bonds include the Twenty-Four Absolute Return Credit Fund, which invests in shorter-dated bonds, and the Artemis Corporate Bond fund. The latter fund invests in a bonds across a range of maturities.

Fund fact sheets: what to consider

Fund fact sheets are typically updated at the end of each month and therefore yield information displayed on these can date quickly in the current environment where bond yields have been moving around in reaction to the latest economic and inflation data.

Many fund groups will only include one yield figure on their fact sheets, and this is known as the “Distribution Yield.” This measure represents all the income payments over the last year as a proportion of the current value of the fund and is therefore income-only and does not include the annualised gain (or loss) if the bonds in the fund are held to maturity (and do not default).

Current Yields to Maturity are much higher than Distribution Yields because most bond prices are now trading below the value that they will be redeemed at. 

Go deeper – if you’re keen to learn more about rising bond yields, you can read investment expert Ben Seager-Scott’s analysis, A return to fixed income.

How Bestinvest can help

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Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Any stocks named are mentioned purely for illustrative purposes. Details correct at time of writing.

The value of an investment may go down as well as up and you may get back less than you originally invested.