Cash vs bonds - how to play rising interest rates

AS interest rates have risen to combat runaway inflation investors have been turning to cash - but there is more than one way to play high interest rates.

Bonds were a big let-down to investors last year precisely because rising interest rates hurt their performance - but with rates now near their peak many professional investors are viewing them as a buying opportunity.

What should ordinary investors do to make the most of high interest rates?

A rush to cash

For the first time in many years cash is paying a return high enough to turn investors’ heads. The top-paying savings accounts in the UK now pay 4% with no strings attached. If you’re willing to tie your money up for a year the rates go as high as 5.4%¹.

That’s significant because many investors will target that level of return to hit their financial goals. For example, 4% is an oft-used level for withdrawals from retirement funds, so assets which grow by at least that much - and with no chance of nominal losses - become very attractive.

However, the practicalities of cash savings - and the tax they attract - can complicate things. For returns on savings to be tax-free they need to be held in an ISA and returns on cash ISAs are lower. The best cash ISA right now pays 3.65% if you want easy access to your money.

Money saved outside ISAs is potentially liable to tax. We all have an allowance for savings interest each year before tax applies - £1,000 for basic rate taxpayers, £500 for higher rate payers - but returns above that level will be taxed as income.

Some investors have turned instead to money market funds - funds which invest in instruments providing a cash like return. Money market funds have attracted a flood of cash this year from investors. The funds have been particularly useful for those looking to reallocate money held inside pensions, which can’t usually be held in cash accounts.

While the logic of holding cash makes sense on the surface, there are hidden risks. Rates are high precisely because inflation is high, and inflation will erode the value of cash unless it produces a return which can outpace the rise in prices. Currently, headline inflation in the UK is 8.7% - lower than the peak of 11.1% hit last October but still way above the best paying cash accounts. So even money held in these is losing value in real terms.

Inflation is forecast to fall further. Meanwhile, the Bank of England is forecast to raise rates even higher - the Bank Rate is now expected to reach 5.5% by the end of the year². That creates the possibility that returns on cash could overtake falling inflation at some stage, opening a window for cash investors to at last secure an inflation-beating return.

But is that the best way to play a fall in interest rates?

Bonds disappoint - but are they due a rebound?

2022 was hard for most financial assets, but the losses for bonds were perhaps the most painful for investors. Bonds are traditionally lower risk than shares and are often held because they can be uncorrelated to stock markets. Last year upended that assumption and bonds fell at the same time as shares.

Rising interest rates will always hurt the price of bonds because, when rates rise and investors can get a higher-risk free return elsewhere, they demand a higher yield from fixed income investments like bonds. Bond prices will then fall until the yield paid rises to a level that keeps investors satisfied.

Stock markets fell last year because inflation took off and threatened economic growth, but also because the biggest companies in stock markets were sensitive to rises in interest rates - just as bonds were. These included high-quality ‘growth’ companies - those with robust earnings that investors expected to grow in the future. Rising inflation and rates eroded the value of those future earnings and share prices fell.

The result was falls for both shares and bonds and many portfolios set up to protect investors suffered the heaviest losses. Figures quoted recently by Schroders³ showed that investors in funds from the lowest risk Investment Association sector (those investing between zero and 35% in shares) fell by just as much last year as those in the highest risk sector (those investing between 40% and 85% in shares).

This year the performance of stock markets and bonds have diverged once again. Bonds have continued to fall as expectations for interest rates have continued upwards, while shares have bounced back.

With interest rates now approaching their peak, could bonds be due a reversal of fortune? Those buying into bonds now benefit from the higher yields being paid on bonds. Yields on 10-year UK Gilts - bonds issued by the government where the risk of default is negligible - reached 4.43% last week compared to just 1% at the end of 2021⁴. That’s comparable to the best cash rates and a sizeable buffer against further capital losses should rates rise further.

But if confidence grows that interest rates expectations have peaked, investors buying now could benefit from capital gains as well. Schroders calculated that, thanks to the high yields currently being paid, prices would not need to recover to the level seen before last year. In fact, a fall in yields of just 1% could be enough to recover the losses made last year, it said.

That would place bonds in a sweet spot.

How to invest in bonds

Bond investing can be a complex business but ordinary investors don’t have to tackle the task alone. Bond funds can manage a portfolio of bonds for you. Our Select 50 list of favourite funds includes 11 bond fund options. These include the Colchester Global Bond Fund which invests in government bonds from major economies around the world.

For a low-cost option, the iShares Global Government Bond ETF tracks a global bond index for a charge of just 0.2%.

Source:

¹ MoneySavingExpert, 15 June 2023

² The Guardian, 12 June 2023

^3,4 Investment Week, 31 May 2023

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Tax treatment depends on individual circumstances and all tax rules may change in the future. Select 50 is not a personal recommendation to buy or sell a fund. The Colchester Global Bond Fund and iShares Global Government Bond ETF invests in overseas markets so the value of investments could be affected by changes in currency exchange rates. The funds also invests in emerging markets which can be more volatile than other more developed markets. The Colchester Global Bond Fund uses financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.