The benefits of investing in bonds
05 December 2016 | Peter Westaway
Many investors are currently concerned that inflation in the United Kingdom will cause interest rates to rise. If this happens, there is a risk that value of bonds currently in issue will go down.
Background to UK inflation
In the UK, the vote on June 23 to leave the European Union triggered a sharp fall in the exchange value of sterling. On the day of the vote, the pound was worth US$1.49. By mid-November it stood at US$1.24, a fall of nearly 17%. Against the euro, the pound was down from €1.31 to €1.16.
This was in part due to expectations that the UK economy would shrink as trading conditions with the EU became more challenging. It was also in part due to the Bank of England cutting its base rate from 0.5% to 0.25%, while promising an additional £70 billion in quantitative easing (QE).
The lower level of the pound is already impacting price in shops. There have been stories of supermarkets struggling with suppliers to limit price rises, including one involving Marmite! The National Institute of Economic and Social Research has predicted consumer inflation rising to 4% by the end of 2017. The Bank is predicting 2.8%.
Both of these forecasts are significantly above the Bank's 2% target for consumer inflation. Does this mean the Bank will raise interest rates? And if it does, will the value of bonds inevitably fall?
Likely response from the Bank of England
In normal circumstances, inflation running from 3–4% would almost certainly provoke an increase in Bank interest rates. But no circumstances are ever quite normal. The rise in UK inflation, if and when it comes, will be due to a rise in the price of imported goods, a result of the fall in the value of sterling.
Much of what the UK imports is consumer goods, food, clothing and especially fuel. For many people, this will mean day to day expenses going up, while incomes remain relatively flat. Households will need to cut back on spending just to stand still.
Instead of inflation being a product of the economy growing too quickly, it may be a cause of the economy slowing down.
In our view, the Bank is likely to 'see through' the causes and effects of the current cycle of inflation. It may rein in its QE programme. It may even bring the base rate back to 0.5% or edge it a little higher still. It is unlikely, though, to go further than this, if it even does this much.
Outlook for bond investors
There has already been a fall in bond values. This partly reflects unease over the direction of interest rates. But it is also a response to the prospect of looser government spending, and the possibility of higher borrowing, both in the UK and the United States.
While this may be difficult for investors to bear, we should always be extremely wary of 'playing' the market, selling when valuations fall or buying when they rise. This can often lead to additional, and unnecessary losses, as the markets continue to chop and change direction.
The immediate trading value of the bonds investors hold may have fallen, but the cash flows from them, the coupon payments and redemption value, remain the same. As coupons are paid and existing bonds redeemed, these cash flows will be reinvested into higher-yielding bonds. These higher yields will in time help to recoup the loss of value in the bonds currently held.
Investors should not, in our view, underestimate the value of bonds as a diversifying element in a portfolio. The recent fall in bond values has been accompanied by a rise in the value of equities. Should there be another change in the market, and should equities fall, it is likely that bonds will rise. This balance between bonds and equities is an important mechanism to maintain the overall value of a portfolio over time.
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