FTA Vantage Point: Interest Rates  

What higher interest rates mean for bonds

  • Discover the relationship between interest rate movements and bond yields.
  • Understand how different central banks are approaching monetary policy now.
  • Learn about the range of outcomes that hit bond investors as rates rise.
CPD
Approx.30min
What higher interest rates mean for bonds

The best selling single in the UK in 1991 was Bryan Adams' “Everything I do (I do it for you)”, but the rather saccharine ballad remains more prevalent today than do the monetary conditions of the time.

This is despite the respective inflation rates being largely the same – the reasons for this will largely determine the outlook for bonds as interest rates rise.

In March 1991, around the time Adams was recording his biggest hit, inflation in the UK rose above 7 per cent, the 10-year gilt yield was 10 per cent, and the UK base rate was 12.5 per cent as policymakers strove to drive inflation lower.

As we approach March 2022, the UK inflation rate is expected to peak at around 7 per cent but the base rate is a mere 0.5 per cent, having recently been restored to the level it was at the start of 2020 when inflation was very low, while the 10-year gilt presently offers of a yield of 1.5 per cent. 

Bruce Stout, who runs the £1.7bn Murray International investment, says the reason for the disparity is largely that central banks have, in the years since the global financial crisis, deployed the policy of quantitative easing, which involves the purchase of enormous quantities of bonds.

This pushed the yield on bonds downwards, and was designed to drive people out of safe-haven assets such as government bonds and cash, and into riskier assets that can have a more positive impact on economic growth.

That created an uneconomic buyer in the market – that is, central banks – purchasing bonds regardless of valuation, keeping prices high and so yields low.

Those low yields percolated into equity markets and house prices, as investors, wary of high bond prices, sought out other investments. 

Return to normal?

The decision by various central banks to lift interest rates this year, and also to halt bond buying, restores, says Stout, a more normal cycle for bonds and for markets as a whole.

Higher interest rates are a negative for the bond market in several ways. The first is that if investors can get a higher return on cash at the bank then they have less incentive to buy a low-risk asset such as a bond.

But, more broadly, after interest rates rise, new bonds coming onto the market will have to offer a higher interest rate than did previous bonds of the same type in order to compensate for the fact that the interest rate on cash has risen, and the gap between the interest on bonds and on cash, known as the spread, has narrowed.

With new bonds coming to the market at a higher interest rate than identical bonds of a similar type that are already in the market, the price of the old bonds declines, as demand to own them falls, with investors preferring the newly issued bonds with the higher interest rate.  

In addition, higher interest rates are bad for bonds because the income is fixed – and as inflation rises, the spending power of that income declines.