Why have I lost money on gilts?

Important information -  the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Q: I invested in long-term gilts expecting that as interest rates fell they would increase in value. I am currently 10% down in capital terms. Not a big problem as I am invested long term but I don’t understand why. Any thoughts?

A: Your logic was impeccable, but unusual market movements have, for the moment at least, knocked your strategy off track. 

You are right that falling interest rates are normally good for bonds, as we recently explained in our article ‘The investments to consider when interest rates fall’. When the amount of interest you can earn from a savings account falls, you may decide to buy bonds instead. If the market as a whole does this, the increasing demand for bonds pushes up their prices so that their yield (the annual interest payment divided by the price) falls in line with the decline in interest rates. Bond yields fall when their prices rise and vice versa. 

This is what normally happens. In recent months, however, some unusual things have happened in the bond markets. We can trace part of the problem back to America and Donald Trump. 

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Ever since Mr Trump announced the ‘liberation day’ tariffs on 2 April, investors all over the world have fretted about the implications for markets and economies. One of their first reactions was to sell bonds issued by the American government. They probably had a mix of reasons, including that tariffs would spur inflation by making imported goods more expensive (inflation is bad for bonds unless they are inflation-linked, which most are not) and that America was becoming less trustworthy and predictable as a home for investors’ money.

Government bond markets around the world often take their cue from what happens in America, and this time was no exception. When investors sold US government bonds the yields rose, as they must, and yields on British government bonds or gilts moved up in harmony. All of this happened despite the cut by the Bank of England to Britain’s official cost of borrowing in May. This highlights an important point about what we call ‘interest rates’: interest rates for short-term purposes are indeed set by the Bank but long-term rates are dictated by the market. Very often short-term and long-term rates move up and down in broad alignment but occasionally, when the markets or the economy are behaving in an unusual way, they can diverge. 

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If, as the Bank expects, inflation falls back towards the 2% target after the current rise, it is likely to keep cutting rates. All else being equal, this should help to reduce long-term rates – in other words, gilt yields should fall and your gilt investments should recover some ground. But in the current febrile economic and political environment, such a benign course of events cannot be taken for granted.

We should say that not all of the divergence between gilt yields and the Bank of England’s Bank Rate can be blamed on Mr Trump’s tariffs. As the graph shows, the two measures had started to move in opposite directions last year. We can probably attribute that, in part at least, to concerns about rising levels of government debt in Britain, America and elsewhere. Increased government borrowing means the issuance of more government bonds, and that increase in the supply of bonds means, all else being equal, a fall in price and therefore a rise in yields.

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