Bond Watch: UK inflation drop is not the good news it seems

Sam Benstead breaks down the latest news affecting bond investors.

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.

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Here’s what you need to know this week.

Inflation drops but markets are worried

Headline inflation in the UK fell from 10.1% in the year to March, to 8.7% in the year to April, but the news was not received well by financial markets.

Investors were spooked by a rise in “core inflation” of 6.8%, up from 6.2% in March. This measure of inflation strips out energy, food, alcohol and tobacco prices, which tend to be volatile as they are heavily influenced by commodity prices which can rapidly rise and fall.

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Core inflation readings are therefore “stickier” than headline inflation statistics and suggest inflation will be harder to bring down than previously thought.

Neil Birrell, chief investment officer at Premier Miton Investors, says: “UK inflation is undoubtedly moderating, but much more slowly than expected.

“There is little good news in the Consumer Prices Index (CPI) data released, which probably leaves the Bank of England with little choice but to keep interest rates moving higher when they next meet. With much of the economy remaining robust, they will probably think that it can cope with tighter monetary conditions. The problem is that when that bites, it could lead to a sharper slowdown.”

Bonds fall, sending yields higher

Investors are now betting that interest rates will max out at 5.5%, from 4.5% today, which has put pressure on bond prices.

Bond prices tend to fall when interest rates rise, as newly issued bonds will come with higher yields. Lower bond prices push up the yield on existing debt.

Gilts maturing in a decade now yield 4.3%, while those maturing in one and two years yield 4.8% and 4.4%.

These are around the same yield as during the mini-budget turbulence last September – a level that rewarded investors for buying during that period as bond prices then rallied when Jeremy Hunt took over as chancellor.

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While a yield above 4% is appealing for investors in UK government bonds, the return is still below the inflation rate, so holding the bonds to maturity could still lead to a loss in “real” terms if inflation does not fall back to the Bank of England’s 2% target.

High interest rates will put more pressure on the economy, as more household income is diverted into paying mortgage and credit card debt. In the case of a recession, bonds issued by the UK government and the most financially secure companies are expected to perform well.