Investors pile into UK government bond funds, but are they making a mistake?
3rd November 2022 12:12
by Sam Benstead from interactive investor
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Buying UK government bond funds and bonds directly carry different risks and opportunities, explains Sam Benstead.
British investors poured money into bond funds in September, with UK Gilt (government bond) and UK Index Linked Gilts the best-selling fund sectors, according to industry body the Investment Association (IA).
In total, £614 million flowed into the two sectors, with UK Gilts taking around two-thirds of that money.
Despite the move into bonds, UK savers took £7.6 billion out of funds in September 2022, marking the eighth month of net retail outflows this year.
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This is the second highest-ever outflow from retail funds, after March 2020 when outflows hit £9.7 billion, according to the IA.
UK government bonds sold off sharply in September because the mini-budget tax cuts and spending pledges from former prime minister Liz Truss undermined the financial credibility of the UK government and spooked investors.
This caused bond yields to rise, which increased the income payments for new investors in UK government bonds, therefore attracting inflows.
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For example, the 10-year UK Gilt rose from a yield of about 2.8% at the start of September to 4.5% at the end of the month.
The U-turn on nearly all the policies introduced by Truss by the new chancellor, Jeremy Hunt, as well as the new prime minister Rishi Sunak, who is considered fiscally conservative by markets, has calmed bond markets. The yield on the 10-year gilt is now around 3.5%, reflecting higher bond prices.
Investors have two options when adding UK government bonds to a portfolio: they can either buy a bond fund or invest in gilts directly.
Bond funds own a basket of bonds with a range of maturity dates. They are constantly churning the portfolio as new bonds are issued by the government and added to the fund, and some bonds mature, which raises cash to be reinvested.
This basket of bonds will rise and fall in value as interest rate expectations change. Income payments are slow to catch up with rising bond yields as higher-yielding bonds are gradually added to the fund.
This means that the “distribution yield” – or how much investors expect receive in income every month – will be below the “yield to maturity” on government bonds, which includes the return of an investor’s principal as well as income payments.
Investors can also buy gilts directly. By holding them to maturity and seeing their principal returned, they will lock in a higher income than owning a bond fund.
The UK government is all but guaranteed to honour its debt obligations, so investors can sleep well knowing that they will receive their interest payments and principal when the bonds mature. Gilts pay interest twice a year.
Sophisticated retail investors were buying gilts on the interactive investor platform to take advantage of higher yields following their sharp sell-off in September and October.
Retail investors preferred bonds set to mature soon, with the five most-popular gilts maturing before summer 2025.
There is an active retail market for gilts, with issues priced at £100, allowing regular investors to own government debt.
Buying bonds directly, rather than via a bond fund, means investors get the full benefit of rising yields if they are looking for income rather than capital gains.
However, a fund has the advantage of owning a diversified pool of bonds. While there is next to no credit risk from UK government bonds, the same is not true from corporate debt, where the ability to pay investors depends on the health of the company.
Chris Cummings, chief executive of the IA, said: “Despite the historic rise in UK gilt yields following the mini-budget, which caused gilt prices to plummet, UK gilts was the highest-selling sector this month as some investors saw opportunity amid the turbulence.
“We have seen outflows from funds in eight of the first nine months of 2022, and while volatile markets can provide opportunities, investors are still waiting for a period of relative market and economic stability.”
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