Benstead on Bonds: why UK investors are getting a great deal on bonds

Investors are flocking to bonds once again to capture attractive yields, which have finally arrived because of central bank tightening following more than a decade of falling interest rates and low inflation.

Data from the Investment Association (the trade body for the funds industry, known as the IA) showed that in July, fixed-income funds saw inflows of £520 million and mixed-asset funds (which also own bonds) saw inflows of £861 million. These were the third and best-selling asset classes for the month, showing how bonds are beginning to offer genuinely competitive alternatives to equities.

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Digging further into this data, something interesting stands out: Sterling Corporate Bond was the best-selling investment sector in July with net retail sales of £287 million. There is now £58.4 billion invested in the sector, which makes it the most popular fixed-income sector, holding about a quarter of all bond assets by retail investors in the UK.

This investment sector refers to funds where at least 80% of the portfolio is invested in bonds that are issued and pay investors in sterling, where at least 80% of the fund has an S&P Global credit rating of BBB minus or above, otherwise known as investment grade.

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Another interesting nugget from the IA’s data trove is that gilt funds were the best-selling investment sector in the second quarter of this year.

My take is that even though investors can get simple and efficient access to bonds from all over the world, just as they can with global equities, they are being drawn to sterling-denominated bonds due to higher yields and the importance of collecting an income in their home currency.

The same can’t be said for UK-listed equities, which are regularly at the bottom of the IA table for outflows, even though there are cheap valuations and high dividend yields on offer.

Why sterling bonds stand out

And they are right to buy sterling bonds as they yield more than bonds in other currencies from developed-world governments or companies.

Take the big four government bond issuers: the UK, the US, Japan and Germany. 10-year yields are 4.4%, 4.3%, 0.7% and 2.7%. Yields from developed-market governments are higher only in Italy (and only just, at 4.47%).

In the corporate bond space, sterling investment grade bonds also yield more than euro and dollar-denominated investment grade bonds, with the gap nearly two percentage points between euro and sterling bonds, but narrower between dollar and sterling bonds.

An index of sterling investment grade bonds (S&P UK Investment Grade Corporate Bond Index) yields 6.2%, US bonds (as per the Markit iBoxx USD Liquid Investment Grade Index) yield 5.7%, and euro bonds (Bloomberg Euro Corporate Bond Index) yields 4.3%.

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Owning debt in your own currency is beneficial because investors do not have to worry about currency fluctuations, nor pay extra fees for fund managers to hedge out the impact of these currency fluctuations.

This means talk of the return on bonds has an even more important meaning for UK-based investors, particularly those who are comfortable buying bonds directly, such as gilts and corporate bonds.

But there’s a good reason yields are higher here

However, higher yields on sterling bond funds are a result of bigger losses over the past few years as interest rates rose, as well as expectations that interest rates will need to be higher for longer in Britain to bring down inflation. Bond investors have therefore suffered, but new investors eyeing up adding some fixed income to their portfolio are in a good position.

Investors must take into account the income they get from bonds, but also how quickly prices are rising, to give them the “real” return.

Inflation is currently 6.8% in the UK, 5.3% in the eurozone, 3.7% in the US. However, the Bank of England reckons inflation will be 5% in Britain by the end of 2023 and return to its 2% target by early 2025. Therefore, assuming inflation returns to normal levels, locking in 4% returns when prices are rising at half that rate, may prove to be a good trade.

T Rowe Price, the US fund manager, says that inflation has begun to moderate, the labour market remains strong, and the economy has proven more resilient than expected. Its view is that UK investment grade credit offers good value over the short term.

However, it notes that wage inflation is very elevated and the Bank of England may be forced to hike rates further.

“The Bank of England is difficult to predict, with further evidence of price inflation easing required for a pause in rates. UK fiscal issues and adverse inflation surprises may continue to weigh on gilts. Market expectations for UK inflation seem much too optimistic, with wage pressures especially remaining elevated,” it said.

American bond fund group Pimco also says investment grade bonds offer good value, with the “market’s massive repricing” offering the “potential for equity-like returns with resilience in the face of a likely recession”.

Daniel Ivascyn, chief investment officer at the group, notes that the bond market’s massive repricing may allow investors to earn the highest real yields in 12 years without taking uncomfortable risk.

“High-quality bonds offer potential for equity-like returns with less volatility and less downside risk than equities – which is expected to be valuable as we confront the meaningful risks of persistent inflation or a hard landing,” he said.

The chief investment officer of Axa Investment Management, Chris Iggo, is also positive on sterling bonds, specifically gilts.

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He says that interest rates are high and even if the Bank of England takes the bank rate to 5.5%, it is close to being done raising rates.

“Inflation is coming down and there are signs the housing market is now starting to feel the effects of higher mortgage rates,” he said.

He adds that the European Central Bank’s 25 basis points rate hike last week and its suggestion that it has now done enough to bring inflation down, means that bonds in general should benefit from the peak in official interest rates.

“There has been a lot of monetary tightening, bond yields are higher than they have been for years, and it is likely that both growth and inflation will be lower in 2024. Real returns to bond investors should be healthy over the next year,” he said.

But it will not all be plain sailing for gilt investors due to long-term worries about the political and fiscal outlook in the UK, according to Iggo.

He adds: “The pension debacle last year has structurally reduced demand for long-term gilts and inflation-linked bonds. There is going to be more supply. International investors are unlikely to increase allocations to the UK given the policy uncertainty a year away from an election, which is likely to see a change in the party in power. And maybe there is more pain in the short term if the Bank of England feels compelled to do more than the one hike that is currently priced in.”

Iggo flags that investors looking to trade a revival in gilt prices are buying UNITED KINGDOM 0.5 22/10/2061 (LSE:TG61)). This bond matures in 2061 and will, in theory, be one of the main winners in terms of capital gains.