Fresh bond market woes: Here’s why investors should worry

Karl 7th Jun 2023 No Comments

Reading Time: 5 minutes

Shockwaves were sent through the bond market at the tail end of last month following the release of new ‘core’ inflation data.

With inflation (minus volatile food and energy costs) now at its highest for 31 years, there’s now a clear realisation that the Bank of England isn’t getting to grips with the situation.

Soaring bond yields now means Government borrowing costs are the highest among G7 countries. In fact, borrowing costs have now risen to a level last seen under Liz Truss – only this time ‘Trussonomics’ can’t be blamed!

So what does this turmoil mean for investors? And how will this latest news impact your pension or mortgage? Keep reading for all the details or click on a link below to jump straight to a specific section…

In brief: What are Government bonds?

A bond is a debt security issued by organisations as a way to raise capital.

When you buy Government bonds, you’re buying a slice of the national debt. In return you can expect to profit on the capital you’ve lent out. In the UK, Government bonds are also known as ‘gilts.’ In the US, they’re known as ‘treasuries’.

While buying Government bonds is a low risk investment – as the state cannot run out of money – the value of bonds can still rise and fall. This is because, like stocks and shares, bonds can be sold to other investors on the secondary market.

Bond prices have an inverse relationship with yields. So when bond yields rise, prices fall. When bond yields fall, prices rise. Read this article for a full explanation.

What has happened to the bond market recently?

Despite being seen as one of the safest asset classes out there, the bond market has had a torrid time of late. In 2022, we saw the bond market have its worst year for decades, with bonds and stocks both suffering – a relatively rare phenomenon.

As a result of last year’s bond performance, even risk-averse investors holding a mixture of stocks and bonds felt a lot of pain.

Much of last year’s bond market fallout was attributed to the tax-cutting economic policies of former PM and Chancellor, Liz Truss and Kwasi Kwarteng. In October 2022, you’ll remember that bond yields soared after markets lost confidence in the UK’s ability to finance its planned tax cuts.

This is mainly the reason why the UK was lumbered with yet another PM at the tail-end of last year. And while current PM, Rishi Sunak, was seen as a stable, sensible economic replacement to Liz Truss – even though he was Chancellor during the Government’s 2020 economic mis-management(!) – this narrative appears to be changing…

On Thursday 25 May, gilt yields once again started to soar following the release of ‘worse than expected’ core inflation data, which was 6.8% in April.

Following this revelation 10-year yields hit 4.37% on this day. Two-year gilts, meanwhile, hit 4.49%. This pretty much puts us back to where we were during the ‘Trussonomics’ era last year.

Strikingly, UK borrowing costs are now higher than any other country in the G7.

What does this all mean for investors? And is it time to worry?

When inflation data is unexpectedly high, it’s a near certainty that the Bank of England will have to raise interest rates in an attempt to curb it.

The base rate is already 4.5%, and it’s now a question how much its Monetary Policy Committee will choose to hike rates when it next meets on Thursday 22 June.

When interest rates rise – or when interest rates are expected to rise – the value of stocks and shares typically falls. That’s because higher interest rates, by definition, raises the cost of borrowing, and generally makes things more expensive for businesses to exist.

Similarly, businesses relying on consumers to purchase their goods and services may also suffer. This is because when interest rates go up, consumers may be more inclined to make less frivolous purchases – especially when interest rates on risk-free savings accounts also go up. In other words, rather than spend frivolously, it makes better financial sense to keep cash aside.

For the bond market, this is a similar reason as to why higher interest rates often leads to a fall in bond prices and a rise in yields. That’s because when interest rates rise, it comes easier to earn higher rates on risk-free assets. So to compensate for this, bond yields have to rise in order to attract new bond investors. This is bad news for holders of existing bonds.

Should we continue to see a wobbling economy which, let’s face it, is more than a possibility, we could see bond yields rise even further. This is why investors holding bonds right now should think very carefully about rejigging their portfolio.

To learn more about investing in uncertain times, take a look at our article that explains some strategies on how to navigate market volatility.

How does rising bond yields impact pensions & mortgage rates?

Because bonds are considered a very safe asset class – mostly because they have fixed liabilities – many pension funds include bonds. This is why, even if you don’t directly invest in bonds yourself, if you have a pension – such as a workplace pension – there’s every chance you’ll have at least some exposure to bonds.

You may remember the worries surrounding pension funds last year when bond yields started to soar. Well this is one of the reasons why a stuttering bond market can have such a massive impact on those with a pension pot – especially those nearing retirement.

In terms of mortgage rates…. as discussed above, when bond yields rise because of high inflation, it’s a near-certainty that the Bank of England will increase interest rates. Higher interest rates raises the cost of borrowing, which is why mortgage rates rise in such a scenario.

A range of mortgage lenders have already priced-in the expected rise next month following the recent bond market turmoil. For example, Nationwide raised its fixed mortgage rates by 0.45 percentage points on Friday 26 May. Meanwhile, Halifax, Santander and Atom Bank have raised their respective rates by 0.2 percentage points.

Should the trend of rising inflation and bond yields continue, then it’s fair to say that other mortgage providers are likely to follow suit. It’s now a question of high high mortgage rates will go before they peak. Some expect the Bank of England’s base rate to peak at 5.5% in 2024, but given how unreliable the experts have been over the past few years, you’ll be forgiven for taking these sorts of predictions with a pinch of salt.

To learn more about investing during high inflation, see our article that highlights some investments that typically do well when inflation is high.

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