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Charlie asks: I am reading a lot about the bond market in the newspapers and saw that UK government debt now yields more than 4%. This is a great annual return, particularly if it comes with the tax benefits of being inside an ISA or a SIPP. This is also about the same yield as the FTSE 100, but comes without the risk that share prices will fall.
So, can I really get a 4% yield by investing in bonds and are there any hidden risks I need to know about?
Sam Benstead, deputy collectives editor, interactive investor, (pictured above) says: The bond market – often on the fringes of even the financial press – is headline news at the moment.
Kwasi Kwarteng’s mini-budget last week was the one of the biggest-ever days of tax cuts in British history, with the 45% tax rate for those earning more than £150,000 scrapped, stamp duty reduced and a planned rise in corporation tax abandoned, among other measures.
The reaction from financial markets was to effectively downgrade the credit quality of the UK government on fears of more inflation, higher interest rates, and even the very remote possibility that the government would not be able to pay its creditors.
They sold UK government bonds – known as gilts – which therefore sent the yield higher on these bonds. Owning a gilt set to mature in five years offers an annual return of 4.5%. Bonds maturing in two years return 4.4% and those maturing in 10 years return 4.2% a year. UK government bonds are all but guaranteed to pay their interest obligations and return capital on maturity.
Higher yields on gilts also sparked a repricing of riskier corporate bonds. The safest corporate credit – known as investment grade – now yields about 6% for new buyers. Higher-yielding “junk bonds” return even more, as do emerging market bonds, but they carry a greater default risk.
So, is locking in a high yield as simple as picking a bond fund and collecting the income payments? Yes and no. While buying bonds today offers high yields, fund managers already have portfolios of old bonds.
Because the yield is a calculation based on the price you buy a bond for and its annual interest payments, a portfolio of bonds built over years will not be as high yielding as the current market prices.
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For example, while the yield on a gilt portfolio (such as L&G All Stocks Gilt Index Trust) is rising as it adds new higher-yielding debt, the portfolio still only yields 1% because it is packed with low-yielding debt issued over the past decades.
Investors willing to buy their own gilts will get the headline 4% yield, however, so long as they hold the bond to maturity. Gilts pay income twice a year.
The retail gilt market prices bonds initially at £100 to allow smaller investors to lend to the government. For example, UK Government bond UK(GOVT OF) 5% STK 07/03/2025 GBP100 (LSE:TR25) yields 5% and matures in about two a half years. Given that the bond trades around par, a retail investor putting £10,000 into this bond would expect to be paid £1250 in interest payments (in five payments of £250) and then receive their £10,000 back in March 2025. The London Stock Exchange website has more information on the dates of coupon payments.
Greater levels of bond diversification can be achieved through owning a fund. The increase in yields this year has meant that many bond funds now yield more than 4%. Data from FE Analytics, a fund data firm, shows that 104 bond funds that yield more than 4%.
These include ACE 40 recommended funds Rathbone Strategic Bond (4.5% yield) and Liontrust Sustainable Future Corporate Bond (4.2%), and Super 60 members Jupiter Strategic Bond (4.6%); Royal London Global Bond Opportunities (6%); and M&G Emerging Markets Bond (6.5%).
However, income yields are just one element of returns. Bond prices also matter. If interest rates keep rising, then investors will keep selling bonds. This pushes up yields, but drives down price. So while the income on offer will rise, the amount an investor will be able to cash out their portfolio for will fall. The “total return” may well be negative, even though the income is high.
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