Where are we in the interest rate cycle?
Whilst central banks continue to steer economies toward their 2% inflation targets, it’s looking likely we’ll see a delay in the start of the interest rate cutting cycle. Inflation in the major western economies peaked around 10% in 2022 following energy price spikes and the extreme monetary and fiscal policies adopted to protect economies during the covid pandemic. Price rises have now slowed, but inflation is proving stickier than anticipated and whilst developed market central banks are predicted to start cutting interest rates in 2024, expectations for the first cuts have been pushed back to later than previously expected. Forecasts for the number of cuts we’ll see this year have also been reduced: rates will be higher for longer than anticipated. This does, however, present opportunities, particularly in fixed income markets, with the sweet spot driven by elevated rates extending into the autumn.
To combat accelerating inflation in the US, the Eurozone and in the UK, the Federal Reserve, the European Central Bank and the Bank of England increased interest rates steadily throughout 2022, lifting them from near-zero to levels not seen since before the Global Financial Crisis of 2008. The delicate balance between reducing inflation by slowing economic activity and avoiding a recession has however been successful and, although still above the target level, inflation has been reduced and a “soft landing” (economic slowdown without recession) has been achieved. Central Bank interest rates now sit at 5.25% and 5.25%-5.50% and 4.5% in the UK and US and Europe respectively.
Generally, equity and fixed income markets respond negatively to rising interest rates. Higher rates increase the cost of debt, which in turn may impact scope to spend and invest for corporates and private individuals alike which reduces economic activity. When interest rates increased 2022, equity markets and fixed income markets responded by falling on average by more than 15-20% as measured by the MSCI World Equity Index and the Bank of America Global Fixed Income Markets Index: equity markets responded to the possibility of a slowing economy, and bond market prices adjusted to match the prevailing base rates. Whilst investors will have seen the value of their bond holdings fall, opportunities have however emerged in the fixed interest markets, particularly in gilts and other qualifying corporate bonds which were issued with low coupons and thus could, at maturity, realise a capital gain that is free of capital gains tax.
Fixed income investments
If held to maturity, fixed interest investments provide predictable returns. They have pre-defined interest returns (coupons), and a pre-defined life at the end of which they mature, and investors receive the nominal value of the bond. The fixed return profile of these types of investment mean they may also experience less volatility than equities and the features that determine the potentially volatility of a bond are its coupon (the level of interest that is paid to the bond holder), the time to maturity and the creditworthiness of the issuer.
Because coupons are fixed at the time the bond is issued, there is an inverse relationship between interest rates and bond prices. When interest rates rise, bond prices fall. This ensures that the return from holding cash on deposit does not exceed the return from holding a bond, thus compensating the investor for the added risk of holding bonds vs cash.
How can investors benefit from investing in government bonds?
Government bonds with low coupons are in focus now because of tax treatment of any capital gain that is realised when they mature. As an example, two bonds with the same maturity month, but with different coupons will produce the same return (currently about 4-4.5% for a short-dated bond), but this return will be split differently between the interest part of return, which is subject to tax, and the capital element, which is free of tax.
So, investors now have the choice as to how that return is divided between interest and capital. Higher coupon bonds will pay more of the return by way of interest, whereas low coupon bonds may provide the investor, depending on their tax status, with a tax-free capital gain. A government bond will be priced below face value if the coupon is lower than the prevailing Bank of England rate of interest. If for example, the interest rate is 5% and a bond has a coupon of 1% and the value at maturity in a year’s time of £100, we might expect the bond to be priced around £96. This is simplifying matter to demonstrate a general principle, but the investor in this scenario would receive £1 in interest (coupon) and £4 capital gain, giving a total return of £5, which matches the cash deposit rate. UK government bonds do not attract capital gains tax, so the net return for the client may be enhanced.
When selecting investments, a diverse investment portfolio will remain advantageous to investors over the long term. We recommend discussing your options with an experienced professional, to deliver a portfolio in line with your attitude to risk and selected investment time horizon. Our investment team are available to discuss your options for the future.
The value of your investment can fall as well as rise in value, and the income derived from it may fluctuate. You might get back less than you invest. Currency exchange rate fluctuations can also have a positive and negative affect on your investments. Please note that EFG Harris Allday does not provide tax advice. Past performance is not a reliable indicator of future performance.