- Rising interest rates have seen money market funds and bonds grow in popularity among investors
- Money market fund returns shot up in 2023
- Bond funds are also offering more compelling value
- Buying individual gilts is also an option but it may not be for everyone and investors need to do their homework
“After such a prolonged period of exceptionally low interest rates, in which equities generally delivered the goods, most investors are likely to have overlooked money market funds and bonds in their search for returns,” says AJ Bell head of investment analysis, Laith Khalaf. “As interest rates climbed, however, bonds and cash-like investments have come back into fashion with Stocks and Shares ISA investors looking to benefit from rising rates, without the need to switch their money to a bank or building society.
“It’s perfectly possible to benefit from higher interest rates within a Stocks and Shares ISA, as it’s not just cash accounts at the bank which pay interest. As with a Cash ISA, your interest in a Stocks and Shares ISA is protected from income tax, so you don’t have to hand over any of the return your money is generating to the taxman.
“For investors that want to add some lower risk investments to their portfolio and still earn a decent return this can be attractive. It could be especially appealing to retired investors who want to hold cash or lower risk investments as part of their drawdown plan too. It also allows investors to keep their money inside their stocks and shares ISA or pension, rather than switching to a cash account, allowing them to invest in other assets again easily in the future if they choose, all within the same tax-efficient wrapper.”
Here are some of the investments available within a Stocks and Shares ISA which are now enjoying better returns because of higher interest rates:
Money market funds
“Money market funds saw rising demand from Stocks and Shares ISA investors in 2023 and this trend has continued so far in 2024. These are funds which invest in cash-like instruments that can be converted into cash quickly.
“They predominantly invest in short-term deposits with banks, and short-term loans to governments, banks and large companies. Some of these loans take place for as short a period as overnight.
“Investors probably chose these funds in 2023 because they are low risk and yet were offering very respectable yields as interest rates rose, in sharp contrast to returns in the prior decade.
“The chart below shows the return from the average money market fund last year was 4.66%, though past performance is no guarantee of future returns. The yields offered by these funds are variable, and depend on short-term interest rates, but clearly these are now much higher than they were in the 2010s.
Source: Morningstar total return
“Money market funds typically have low levels of volatility, which might interest more cautious investors.
“There are two sectors containing money market funds called the Standard Money Market sector and the Short-Term Money Market sector. Funds in the latter are required to hold more of their portfolio in short-term assets, in theory making them more liquid and secure.
“Fund charges for these funds are generally low, on average just 0.16%*, but in the days when the base rate was only 0.1%, those charges could easily result in a fund posting negative returns.
“Now interest rates are above 5% there’s much more jam left over for investors, though there’s never a guarantee of returns and you should still pay close attention to charges. Platform fees for holding these funds should also be considered when investing.”
Bond funds
“Bonds are essentially an IOU, whereby investors lend money to governments and companies in exchange for a set rate of interest, with the original face value repaid at a set date in the future.
“For many years the rate of interest paid by bonds was uninspiring, causing some to describe government bonds as ‘return-free risk’. But that’s all changed since interest rates have risen and it’s now possible to pick up more appealing yields from bond funds.
“Bond funds can and do fluctuate in value, and if interest rate expectations rise, you can expect to see bond prices fall.
“Clearly fluctuations in valuation does mean there is some risk, but bonds can lower the volatility of your portfolio as a whole if you are also holding shares. That’s because bonds, especially government bonds, tend to move in the opposite direction to share prices, so if you hold both in your portfolio, you should get a smoother ride.
“Some bond funds invest predominantly in government bonds, others invest almost exclusively in corporate bonds, while strategic bond funds tend to have a fairly wide remit in terms of the areas of the bond universe that they can invest in.
“You may also come across high yield bond funds, which invest in the debt of companies that have a low credit rating. That makes those bonds riskier, but they usually carry higher yields as a result, which might interest more adventurous income-seekers.”
Individual gilts and corporate bonds
“Investors can buy individual government bonds and corporate bonds instead of a bond fund if they wish.
“Last year we saw an uptick in the number of investors using individual gilts to park large sums of money and lock into higher interest rates.
“Gilts are loans to the UK government, and so it’s pretty certain you will get your loan repaid, along with the interest promised, as there’s a very low chance of the UK Exchequer defaulting on its debt obligations.
“That security is an important feature, especially for those with larger sums who may be concerned bank deposits are only covered by the Financial Services Compensation Scheme up to a maximum of £85,000 if the bank goes bust.
“Corporate bonds are considered less safe because they are loans to companies, which are deemed more likely to default on their obligations than the UK government.
“The price of bonds fluctuates on the market, but there will be a maturity date for each bond, at which point you will get the maturity value of the bond back, unless there is a default.
“The maturity value, also called the par value, may be more or less than you paid for it, depending on the price you bought in at. Many bonds are currently trading at below their par value, in which case the return you can expect back between now and maturity is a combination of interest payments and capital gains.
“Individual bonds can be a bit tricky to get your head around, so this approach is probably best left to more experienced investors or those who are willing to roll up their sleeves and delve into the nitty gritty.”
Multi-asset funds
“Many managers running multi-asset portfolios steered clear of longer-dated bonds during the era of ultra-low interest rates because prices were so eye-wateringly high.
“Now yields have fallen, and prices have fallen back, bonds are very much back in the comfort zone for multi-asset funds.
“Multi-asset funds come in a range of risk profiles to suit investors with different appetites for volatility, so the amount of exposure you can get to bonds and cash ranges from very low to very high.
“These funds might interest investors who want a mix of assets in their portfolio but want a professional fund manager to pick and choose what to invest in.”
*Source for fund charges and performance is Morningstar
