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Don’t fret: higher rates might not be so bad for sterling investors

Picture of Althea Spinozzi
Althea Spinozzi

Senior Fixed Income Strategist

Summary:  A deeply inverted yield curve in the United Kingdom is opening opportunities to savers and investors. Although the Bank of England will keep dovish for longer, two-year Gilts pay 5%, the highest yield since the 2008 global financial crisis. At the same time, UK corporate bonds offer, on average, a yield of 6.2%. As the FTSE 100 returned 4.5% in 2022, UK government and corporate bonds become preferable over stocks as they offer comparable returns exposing portfolios to much lesser risk. Yet, the key is to limit investments to high quality and low duration as the macroeconomic backdrop gets clearer.

Today, the Bank of England hiked interest rates for the thirteenth time in a row by 50 basis points. Governor Andrew Bailey said that inflation is too high and that the resilient economy allows the implementation of such restrictive measures.

The UK sovereign yield curve accelerated its inversion as the market fears that such an aggressive posture might take the economy into a recession.

Although we are navigating uncertain waters and the risk of a recession is rising, not everything is as bad as it looks.

Savers are now given the opportunity to put their cash at work at 5% in two-year Gilts, a level not seen since the 2008 Global financial crisis.

For those willing to take more credit risk, high-grade corporates with one-to-three-year maturity offer more than 100 basis points over Gilts, an average yield of 6.2%. That's not bad if we think that bonds are safer than stocks and that the total return for the FTSE 100 in 2022 was 4.5%.

Tips and tricks to limit risks while maximizing returns

It all comes down to limiting investments to high quality and low duration.

We believe that the Bank of England will continue to have reasons to keep more aggressive than its peers. Therefore, the probability is higher for rates to move up rather than down. 

Because the bond price is negatively correlated to yields, if you were to hold bonds in your portfolio as interest rates rise, your portfolio's mark-to-market value would fall. Yet, the beauty of bonds is that, if held until maturity, you lock in their yield at the moment of purchase. Therefore, you will continue to receive the same coupon throughout the bond's life despite where prices go. At maturity, you will get the bond's notional back even if it is priced at a deep discount in the secondary market due to higher interest rates.

With bond funds, rising rates will affect the fund’s bond prices, but new investments will lift yields in the portfolio as higher-yielding bonds replace lower-yielding bonds. Therefore, the total return profile of the fund will increase.

However, when it comes to choosing between one and the other, it's essential to consider the following:

  • Diversification: ETFs are great for diversifying your portfolio because they contain multiple instruments with different profiles. Although some ETFs can expose investors to a specific market, multiple securities are used to achieve such exposure, resulting in lower risk.
  • Your cash needs: investing in cash bonds might be helpful if you know that you will need that specific lump of money on a particular date. Therefore, you park cash to collect an income over the bond's life and wait for your notional back. Although it is also easy to buy and sell an ETF, it's critical to acknowledge that as interest rate rise, part of the fund’s bonds will fall in value, affecting the selling price. Thus, if you need the cash in the foreseeable future, and there are uncertainties regarding the direction of rates, a cash bond investment is preferable.
Source: Bloomberg and Saxo Group.

Which short-term bonds are best for my portfolio?

Short-term, high-quality bonds are better investments in a restrictive monetary policy regime with deeply inverted yield curves. Risk-averse income-seeing investors will be more comfortable holding Gilts rather than high-grade corporate bonds to avoid credit risk. Gilts paying a higher coupon are preferable, such as those maturing in March 2025 (GB0030880693) paying 5% in coupon and those with maturity in October 2025 (GB00BPCJD880) paying a coupon of 3.5%.

In the investment-grade sterling corporate space, opportunities are even more enticing. High-grade corporate bonds with a better rating than UK Gilts offer a sizable pick-up of roughly 50 to 60 basis points over their benchmark. An example is the European Investment Bank bonds with April 2025 maturity paying a coupon of 5.5% (XS0110373569). Investors looking for a larger pick-up over Gilts but wanting to keep invested in well-rated issuers, NatWest 2026 (XS2638487566) pays a coupon of 6.625% for a little bit less than three years of maturity.

Source: Bloomberg and Saxo Group.
Source: Bloomberg and Saxo Group.


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