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Bonds, inflation and interest rates – what it all means for investors

Bonds, inflation and interest rates can be confusing topics, we’ve broken down what it all means for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Changing inflation and interest rates can have a huge effect on the bond markets.

Most bonds pay investors a fixed level of interest. This can make inflation (rising prices for goods and services) bad news for bond prices. If inflation starts to accelerate, it can quickly eat away at how far those interest payments take you. It makes fixed-income bonds a less attractive option for investors.

As lots of countries and economies start to emerge from the Covid-19 crisis, the demand for goods and services has boomed, leading to supply-chain shortages and rising inflation.

The latest figures showed inflation in the UK had surged to 3.2% in August – it’s highest level since 2012 and more than one percent point above the Bank of England’s target of 2%.

The common antidote to rising inflation is to raise interest rates. Central banks will increase the interest rate to try to slow down the economy by making borrowing more expensive. A higher rate of interest in your cash savings account could also mean you don’t need to take extra risk owning bonds – it can be a vicious cycle for bond prices.

In this article, we take a deeper look at the relationship between bonds, inflation and interest rates. It isn’t personal advice. If you’re not sure what’s right for your circumstances, seek financial advice.

Terms to know

Bonds are fixed-income investments where investors lend money to governments or companies for a set period of time in return for regular interest payments.

Coupon is the interest rate the borrower pays the bondholder. It’s calculated on the bond’s issue price (or par value) and expressed as a percentage.

Yields measure the amount of income paid out from an investment based on the latest market price, expressed as a percentage.

Bond prices and interest rates

Bond prices and interest rates tend to be like two passing ships – they move in opposite directions.

If interest rates rise, bond prices fall, all else being equal.

Why? When interest rates rise, it’s easier to earn better rates of interest from cash. This forces new bond issues to offer more appealing coupon rates for the added risk that comes with investing in bonds. With less demand for existing fixed-interest bonds, it ultimately leads to price falls – bond prices are based on supply and demand similar to shares.

Let’s take a look at an example.

ABC plc bond is willing to pay investors an annual coupon of 2% and the current interest rate is set at 1%. In others words, you’d receive an extra 1% as a reward for the extra risk of owning bonds over cash savings.

However, if interest rates jumped to 2%, ABC plc bond is now less valuable to investors. That’s because they could get the same level of return from cash, or even better returns from investing in new bond issues offering 3% for the same level of risk.

The above example is for illustration purposes only. Coupon rates and time to maturity can impact a bond’s price sensitivity to interest rate changes – this is something called duration.

The opposite is true when interest rates fall – the market value of bonds tends to rise.

Existing bonds on the market become more precious to investors as new bond issues have less favourable interest rates, and you earn less interest from cash sat in your bank. This causes bond prices to rise. But as a bond’s price rises – its yield falls.

Past performance isn’t a guide to the future. Source: Bank of England, to 31/12/2020.

During the financial crisis in 2008, lots of central banks drastically cut back interest rates in an attempt to breathe life back into the economy. This led to the bond markets performing strongly over the last decade. However, yields are now at very low levels, which means the income on offer for investors is in short supply.

Interest rate rises are to be expected if inflation continues to gather pace longer term. If this were to happen, investors could see bond prices fall and yields rise which increases the potential for capital losses.

What about inflation?

While inflation doesn’t share the same direct relationship with bonds in the same way as interest rates do. It’s the see-saw relationship between inflation and interest rates that can send jitters through bond markets.

A little bit of inflation isn’t necessarily a bad thing, it can boost growth in an economy that might be stuck in a recession for example.

However if inflation begins to spiral out of control, it can become difficult for businesses to set the right prices for goods and services. Employees’ wages are worth less in real terms too, which can lead to wage rises, which can trigger further inflation. It’s a vicious cycle.

That’s why central banks use raising interest rates as a remedy to inflation.

Higher interest rates make it more expensive to borrow money, encourages people to save more and therefore spend less in the economy. This lowers the demand for goods and services and helps keep price rises lower. And we’ve already talked about why rising interest rates impact bond prices.

It’s important for investors to remember that market headwinds, like inflation or interest rate rises, are part and parcel of investing (it’s never plain-sailing). Staying diversified and investing for the long term – that’s at least five years or more – are two of the most effective ways to navigate any market storms.

Inflation deep dive – should your portfolio be inflation ready?

Investing in bonds

Bonds are an attractive option for investors looking for regular income. But they’re more than a one-trick pony.

Bonds are seen as ‘safer’ investments – they tend to be less volatile than shares which can offer some shelter during market wobbles. This means they could act as part of the core of a conservative portfolio. They can also add some balance to an adventurous portfolio mostly invested in company shares or share-based funds. Remember though lower risk usually means lower reward.

Investing in individual bonds can be very complex with complicated pricing structures. Some bonds, like index-linked bonds, which offer investors shelter from inflation, often requires a large initial lump sum investment which isn’t always suitable for retail investors.

For investors looking to dip into the bond market, we think bond funds could be a good option.

Bond funds invest into a basket of bonds which are hand-selected and run by a professional fund manager. Investors in the fund benefit from their expertise, knowledge and time spent researching for the best opportunities in the market. It’s also possible to invest in bond tracker funds which aim to track the performance of the wider market like-for-like.

Better still, you don’t need to have deep pockets to get started either. You can invest in funds from as little as £25 a month by direct debit or with a £100 lump sum through HL – offering an easy and convenient way to invest.

We think bonds should play at least some part in investors’ portfolios as a way to manage risk. They might not offer the most exciting way to invest, but investing isn’t a game and ignoring them completely could make for a painful watch if markets take a tumble.

You’ll need to consider your own goals and attitude to risk before making any decisions. Investing in bonds or bond funds won’t be right for everyone – all investments can fall as well as rise in value so you could get back less than you invest.

For more information on bonds, read our latest review on this sector which includes information on our Wealth Shortlist bond funds. The Wealth Shortlist is a list of funds selected by our analysts for their long term performance potential.

Our latest bond funds quarterly review

More on the Wealth Shortlist

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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