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Income investors need to be aware of the significant opportunities and risks that can emerge across financial markets because of developments in the bond market.
UK and US government bond yields have been rising since the end of June. Investors have increasingly priced in the risk that higher energy prices could add to inflation pressures at a time when government borrowing remains elevated and central banks are reluctant to signal imminent rate cuts.
Bond yields move inversely to prices, meaning recent market moves have left many areas of the bond market offering more attractive income opportunities. This has important implications for investors deciding where to generate income, not only within bond markets but also across equities. It also has a direct influence on annuity rates.
Fundamentally, higher yields available today mean investors can earn income levels that were simply unavailable for much of the past decade.
What it means for Gilts and Treasuries
Gilts and Treasuries are terms to describe UK and US government bonds, respectively.
Yields on these bonds have moved higher as investors weigh the inflationary impact of higher energy prices, sizeable government borrowing requirements and the prospect that central banks may keep interest rates higher for longer. That in turn has pushed up expectations for central banks to hold interest rates or increase them.
In early September, Britain sold £4.25 billion worth of 30-year government bonds with the highest yield since comparable records began in 1998 at 5.82%.
At the time of writing in early October, the yield on 30-year gilts had topped 6%; the 10-year gilt traded at 5.51% which was the highest level since 2007; and the 10-year US Treasury yield traded at 5.34%, revisiting levels not seen since 2002.
To put those figures into perspective, on the same day the FTSE 100 index of UK shares offered a 3.3% prospective dividend yield based on forecast payouts for the next 12 months.
Income investors might therefore think that bonds are the obvious place to put their money given the superior yields. However, there are three key areas to consider.
If inflation continues to move higher, the price of existing bonds could fall and lead to new bonds being issued at even greater yields.
Higher borrowing needs or concerns about the public finances can push gilt or Treasury yields higher if investors demand additional compensation for lending to the government.
Investors buying long-dated bonds should remember that higher yields do not eliminate capital risk. If yields continue to rise, bond prices can fall sharply, particularly for bonds with decades left until maturity.
The other key factor to consider is the fact bonds offer a fixed coupon, whereas shares can offer a growing income stream as dividends are not fixed. Inflation can eat into the purchasing power of coupon payments, which in plain English means that the income you receive from the bond might buy you less in the future. Shares have an edge as dividends can often keep pace with, or even outpace, the rate of inflation.
It’s important to take a balanced view with dividends, nonetheless. While dividends have the potential to grow over time and help offset inflation, they are never guaranteed and can be reduced during economic downturns.
None of this means investors should avoid bonds altogether. High-quality bonds have historically helped to reduce portfolio volatility, although longer-dated bonds can still experience significant price fluctuations when yields move sharply. It’s simply about recognising that higher bond yields are not a free lunch for income investors.
What’s the key takeaway?
A decade ago, government bonds had a hard time grabbing retail investors’ attention. Now they are giving shares a run for their money thanks to more attractive yields and typically lower credit risk. A rapid decline in the oil price could quickly change interest rate expectations again and potentially lead to lower bond yields. There is little visibility on whether, or when, that might happen, which means investors should treat the current investment environment as a fluid situation.
Locking in high bond yields now gives you certainty of cash flows if you hold to maturity. Bond prices could rise if higher energy costs slow economic growth enough to encourage future interest-rate cuts. The flipside is that bond yields could rise further such as if investors demand higher yields if inflation proves persistent. In that scenario, bond (and bond fund) prices would fall. What really matters is the return after factoring in inflation.
Rising bond yields: winners and losers
Investors might be thinking about how the shift in the bond market affects what’s already in their portfolio and whether they should rejig holdings and consider new ones. There are some clear winners and losers from rising bond yields, as now discussed.
Potential winners:
New buyers of gilts and Treasuries: Investors buying gilts and Treasuries today can generally obtain higher yields than were available a few years ago, regardless of whether the bonds are newly issued or purchased in the secondary market. AJ Bell customers can subscribe to notifications to receive alerts about upcoming bond offers or view a range of bonds and gilts available for online dealing.
Cash savers: Central banks often keep interest rates unchanged, or raise them, to fight inflation. As of 2 October, the market, on balance, expects the Bank of England to raise interest rates to 4.25% by the end of 2026, implying more attractive returns on cash. AJ Bell’s Cash savings hub is an easy way to access competitive rates on cash.
Annuity buyers: Rising bond yields improve the rates on annuities, which provide a fixed income for life. Annuity providers typically invest heavily in long-term bonds and other income-producing assets to back their income promises, so higher yields feed into better returns for retirees buying these products now. Annuities provide clarity over how much cash you will get each month, but payouts stop at the point of death. In comparison, any money left in a pension at death is left in someone’s estate. Some people use part of their pension to buy an annuity and keep the rest invested – but note that you cannot sell an annuity once purchased.
Annuities can also come in different shapes and sizes, such as being inflation-linked and versions that pay out a proportion to your partner when you die. The amount you get depends on the size of your pension pot, your age, where you live, health, lifestyle, market conditions and the type of annuity to choose. It’s important to understand how each version works and to shop around for the best deal if you decide that annuities are right for you.
Investors reinvesting maturing bonds: With UK and US government bond yields at multi-year highs, it’s possible that investors with maturing bonds might be able to reinvest that money and get a higher yield than they’ve been receiving up to now.
Potential losers:
Existing bondholders: Higher yields make existing bonds less attractive, which typically pulls down their market price. Investors holding individual bonds to maturity would still receive par value at maturity, assuming the government or issuer remains solvent.
Long-duration bond funds: Many investors access bonds via bond funds rather than buying them individually. Bond funds come in different durations, with some investing in bonds that mature in the next one to five years (short duration). Others mature over longer periods (long duration) and are more sensitive to changes in interest rate expectations, making their prices more volatile.
Investors should distinguish between individual bonds and bond funds. A holder of an individual gilt who keeps it until maturity knows what income they will receive and will typically get the bond’s face value back at maturity.
Bond funds have no maturity date, and their value continues to fluctuate as managers buy and sell bonds, meaning rising yields can have a more persistent impact on capital values.
Bond proxy shares such as utilities, REITs (Real Estate Investment Trusts) and telecom providers: Bond proxies are companies whose earnings and dividends are relatively stable and predictable, like the coupon payments from a bond.
Rising bond yields can make their dividends less competitive and their valuations can come under pressure. Investors value shares based on the present value of future cash flows. Higher bond yields tend to push up discount rates used in valuation models. This reduces the present value of future dividends, leading to lower share prices.
Many companies classified as bond proxies have large debts and they can suffer from a higher cost of borrowing which often coincides with rising bond yields. Anyone owning an equity income fund should check the level of exposure to bond proxy-type companies in the portfolio.
Dan Coatsworth: Head of Markets
Dan Coatsworth is AJ Bell's Head of Markets. Dan has been with the company since December 2012 and has more than 18 years' experience in the industry, following the markets and all things investing. He...