Inverted Bonds

Newsflash. Bonds are hot. The normal librarians of the investing world are having a sequined moment on the portfolio dancefloor. Let’s unpack why.

The name’s Bond

Companies can raise month to fund growth in 2 key ways. They either offer people a tiny share of the company in exchange for our money (by selling shares). Or we lend them money by way of a loan, and they pay us interest on this loan (these IOUs are bonds).

Let’s imagine someone wanted to borrow a grand from you. How much would you want in return for making that loan? It depends how dodgy they are. How risky they are. But also how long they want to borrow it for. The same principles apply in the world of finance. If we lend money to the Government, we feel less alarmed than if we lend money to a copper producer in the Democratic Republic of Congo. So we ask for less interest to compensate us.

This is why Government bonds (or gilts) will pay less (or have a lower ‘yield’) than various corporate bonds – in return for giving you a less hernia-inducing path.

How do they work?

Bonds can be tricky to get your head around because there’s a slightly counter-intuitive point that their price goes down when the income they pay goes up - and vice versa. I think of them like a seesaw with yield (interest) at one end and price at the other. Higher interest and yields = lower bond prices.

In a picture-perfect world, with Volvos, 2.2 children and happy, predictable economies, the longer we lend someone money for, the more we expect to get back. If I lend you money for 10 years, I want an interest rate which is higher than if I lend you money for 1 year. I’m tying my money up so make it worth my while. When economists draw a chart with gently increasing rates over time, this is called a yield curve, which normally slopes politely up.

But not so fast Meester Bond, the yield curve is INTROVERTED!

Just imagine we were in such a perilous state that people thought interest rates were going to be jammed up yet further to kill inflation but break the economy in the process so we’d hit a recession and then no-one would spend anything and we’d lose our jobs and interest rates would fall like a stone to try and get us to spend again. Oh ha ha ha imagine such a messed-up world a ha ha ha… oh…

In this scenario you think that interest rates in 6 months might hit 6%. But they could maybe be 3% in 2 years’ time. And even less in 5 years’ time? And actually, we feel so worried about the mid-term future that we’re hungry for certainty and so happy to lock in a pretty feeble long-term rate today, because we see incoming doom. This is upside down. Not normal. Inverted. It basically means you have an Armageddon-y view of the world.

Gulp so what do we actually do?

Putting these signals of an impending recession to one side, from an investment perspective, all this interest rate upheaval presents opportunities.

If you buy a bond today that was issued when interest rates were way lower, you will pay less to get your mitts on this bond than the amount you will get when it comes to a close. This means the interest might look rubbish, but you can make a decent gain.

Here’s a current example. When rates were effectively zilch, the Government issued a bond which pays what now looks like a hopeless yield of 0.25%, which matures in January 2025. This is when they repay you the money you’ve lent them. So in January 2025 you know the Government will pay you £100 for this bond. And today it costs you £92 to buy it. The piddly interest of 0.25% becomes unimportant but that gain of £8 – on an outlay of £92 – over 18 months looks pretty interesting. Oh and here’s another thing for higher rate tax payers – you don’t pay CGT on bonds – so for money sitting outside an ISA or pension this is doubly interesting.

Good God you cry – these bonds are HOT! Easy tiger. But they are worth investigating as a way to diversify, potentially benefit from this point in the economic cycle, and minimise any tax bill. Larger investment platforms will offer up bonds alongside shares so have a dig around if you’re interested. Or investigate bond ETFs as a way to get someone else to do all the leg work for you.

Of course opportunities remain in spades in the world of shares – we just have to look a bit harder than we do in a market where most things are marching up. This week we’ve featured an article on the potential of AI, we’ve worked with Chartered Financial Designer, Rachel Efetha on tips and help for people feeling stressed about money, and we’ve published a new course for people on how to save for the retirement you want.

Over and out for now, have a great weekend everyone.

Holly

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