Rising interest rates have led to government bond yields climbing. It’s made them more attractive to some investors and could provide a way to grow your wealth too.
According to figures in FTAdviser, investors pumped £18.6 billion into UK and US government bond funds between November 2022 and the end of 2023. Of this total, almost £6 billion was placed into funds that invested in government bonds denominated in sterling.
Read on to find out how government bonds work.
Government bonds are a type of fixed-income asset
You can think of government bonds, also known as “gilts” in the UK, as a way of loaning money to the government.
When you buy a bond, the borrower – in this case, the government – promises to pay back the loan at a fixed date, while paying interest at an agreed rate in the meantime. As a result, a government bond could provide you with a fixed income.
Governments use bonds to raise funds for new projects. The maturity date, when the original loan is paid back, can vary from less than a year to several decades.
As a simple example, let’s say you invest £10,000 into a 10-year government bond that has an annual interest rate of 5%. Each year, the government would pay you interest of £500. Then, when the bond reaches maturity in a decade, you would receive your initial £10,000 investment back.
Some government bonds don’t offer a fixed interest rate. Instead, the interest payments move in line with inflation – these are known as “index-linked gilts”.
Bonds are a form of investment, so carry risk. However, when compared to alternatives, such as stocks and shares, government bonds from stable economies are typically considered low risk because the likelihood of the government defaulting on the loan is low.
You can also use bond investment funds that pool together investors’ money to buy a selection of bonds, which may include both government and corporate bonds. Corporate bonds work in the same way as government ones, but may carry more risk depending on the stability of the business.
Investment funds, including those offered by pension providers, will often include bonds to create a balanced portfolio. So, while you might not have purchased bonds directly, they may already make up a part of your investment strategy.
Rising interest rates have led to a jump in bond yields
To encourage investors, government bonds must be attractive when compared to saving accounts. As a result, interest rates can have a direct effect on the return an investor can expect to receive each year, known as “yield”.
To combat high levels of inflation since the end of 2021, the Bank of England (BoE) has increased its base interest rate several times. Indeed, in November 2021, the base rate was just 0.1% after it was slashed to encourage spending during the Covid-19 pandemic. As of February 2024, the rate is 5.25%.
Many other central banks, including the US Federal Reserve and European Central Bank, have taken a similar approach to the BoE and increased their base rate over the last few years. So, bond yields have typically increased too.
FTAdviser reports that in November 2022, a UK 10-year government bond yield was around 3.25%. As interest rates increased, the yield peaked at around 4.75% and was 4% at the end of 2023. Yields have not been this high since the 2008 financial crisis, when interest rates were slashed to then-historic lows and lasted for more than a decade.
While BoE policy cannot be guaranteed, many experts predict that interest rates have peaked as inflation is declining. If the central bank decides to cut the base rate, existing bondholders could benefit. Investors may have locked in a higher interest rate, which could then provide a regular income or make the bonds more attractive to prospective buyers.
Government bonds could form part of a balanced investment portfolio
As part of a wider investment strategy, government bonds may help you diversify your investments to create a balanced portfolio that contains different asset classes. They could also be a useful option if you want to generate a regular income from your investments.
If you have any questions about government bonds and how they could fit into your investment portfolio, please contact us. We could work with you to create an investment strategy that aligns with your goals and risk profile.
Please note:
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
The value of investments and any income from them can fall as well as rise and you may not get back the original amount invested.
Past performance is not a guide to future performance and should not be relied upon.
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