Sam Benstead runs through the most important news stories of the week for bond investors.
Welcome to interactive investor’s weekly ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.
Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.
Here’s what you need to know this week.
A big week of interest rates
It was rate decision week in Britain and the US, with both central banks increasing interest rates at the lower end of expectations. The Bank of England hiked rates 0.5 percentage points to 2.25%, their highest level for 14 years.
Five members voted to raise the Bank rate by 0.5 percentage points, three members preferred to increase it by 0.75 percentage points, to 2.5%, and one member wanted to increase the rate by 0.25 percentage points..
Even though the Bank of England increased rates at the lower end of forecasts – by 0.5 percentage points rather than 0.75 – it signalled that it would “respond forcefully” to persistent inflation and hinted at a bigger rate rise in November when it has made “a full assessment of the impact on demand and inflation” from the coming government fiscal package.
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With the Bank itself saying in its notes that there was a “material risk” of persistent domestic price and wage inflation, even though the energy price cap will bring down headline inflation, bond investors concluded that there could be plenty more hikes to come.
In response, they sold bonds, with the yield of the 10-year UK gilt jumping from 3.3% to about 3.4% following the announcement.
Investors looking for a more dovish pivot from the Bank on the back of optimistic inflation forecasts were disappointed. The outlook for bonds is now tougher, with the Bank worried about inflation sticking around for longer, which would mean rates having to rise higher - this scenario would put more pressure on bond markets.
Rupert Thompson, investment strategist at wealth manager Kingswood, said: “While the Bank said it would continue to respond forcefully as necessary to inflation, it did not follow the lead of both the Federal Reserve and the European Central Bank, which both raised rates by as much as 0.75 basis points in their latest move. The Bank’s decision to increase rates more slowly than its counterparts can only increase the downward pressure on sterling, particularly given the government’s large fiscal boost which is likely to reinforce underlying inflation pressures.”
The US hikes as well
The US Federal Reserve put interest rates up 0.75 percentage points to between 3% and 3.25%. Chair Jerome Powell struck a hawkish tone, sticking with his statement made at the Jackson Hole summit that the central bank will keep raising rates “until the job is done”.
While a 0.75 basis point hike was largely expected by markets, the “dot plot”, which shows where Fed officials expect rates to be in the future, came as a surprise. It suggested that US interest rates could peak at 5% by the end of the year, but then stay that high for 2023 before declining. This means that there could be three more big interest rate increases this year.
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Gurpreet Gill, macro strategist for global fixed income at Goldman Sachs Asset Management, said: “Federal Reserve officials appear increasingly supportive of moving policy further into restrictive territory to prevent high inflation becoming entrenched. This raises the risk of a US recession due to policy tightening, not least because the impact of 3% interest rate rises so far this year will be felt with a lag.
Rate hikes are bad for bonds in the short term, as investors sell their bonds since they can get a better deal on newly issued debt due to higher interest rates. Longer term, this increases how much a bond fund yields, so patient investors see higher income payouts.
But some bonds funds own “floating rate” bonds, which benefit directly from higher interest rates in the form of higher income.
One such fund is the investment trust TwentyFour Income Fund. This week, it said that its minimum annual dividend will increase from 6p to 7p per share on the back of higher income from the debt it owns.
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Aza Teeuwen, portfolio manager for TFIF, said: “As a floating rate fund, the increases in interest rates, which have been unusually coupled with a widening in credit spreads have already materially increased the income that the fund’s assets are generating.
“Given the expectation of further rate rises, a prudent increase in the quarterly dividend payment is warranted to reflect that increased income and also to help distribute the higher returns more evenly throughout the year.”
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