Bond investors have reacted to today’s (2 November) rise in UK interest rates by saying the focus now will be on bonds with a short duration to maturity.
Nicholas Trindale, bond fund manager at Axa, said short-dated bonds tend to perform better in a climate of rising interest rates.
This is because the bonds will mature, that is return capital to investors, in the near future, and the capital can be reinvested into bonds issued at the higher interest rate.
Those who own bonds with a long date to maturity must effectively leave the capital tied up in assets paying an income inferior to that available in the wider market, or sell the bonds at a capital loss to reinvest.
The loss of capital would occur because long-dated bonds with a lower interest rate would be difficult to sell at face value if there are similar bonds paying a higher interest rate also available in the market.
In order to make the bonds with the lower interest rate more attractive, the seller has to take a price lower than face value, which boosts the real interest rate (yield) available on the bonds. This is why when a bond price falls, the yield rises.
Fund managers such as David Coombs at Rathbones take the view that a UK interest rate rise could lead to an economic contraction in the UK.
Short-dated bonds may offer some protection against economic contraction, because they return the capital quickly, so an investor can use the capital to invest in overseas assets if the economic outlook darkens.
Richard Woolnough, who runs the £20bn M&G Optimal Income fund doesn’t believe recession is on the cards in the UK, and said an interest rate rise makes it more likely he will buy UK government bonds, and sell European bonds.
He is investing in short dated bonds as he feels the economy is performing well enough that the bonds of companies that are economically sensitive could start to perform better as the market stops fearing recession.
Guy Stephens, technical investment director at Rowan Dartington has long had a negative view of the investment case for bonds, and this interest rate rise has not changed that.
He said: “A marginal increase of 0.25 per cent is not going to make this asset class any more attractive, especially when any move is largely priced in. The yields remain unfavourable, with the 10-year gilt yield currently standing at around 1.3 per cent - a negative real return.”
David Jane, who runs £770m across three multi-asset funds at Miton, said in the current climate, he would prefer to own short-dated bonds and take extra credit risk to get a higher yield, than the opposite.