When interest rates are low the capital values of fixed rate and high yield bonds rise. So why are we are now negative towards fixed rate bond funds?
A bond is either a loan to a government or a company for a given rate of return, the yield (fixed or index linked) with the nominal value of the bond i.e. the debt paid back at the end of the term. Think of them just like an interest only mortgage or loan.
If you lend money to the government by buying a bond/gilt e.g. for £100 at 2% pa fixed 20 years you will receive £2pa income and capital repayment in 20 years. If the Bank of England’s base interest rates were only 1% pa when you bought, then you are making a premium of 1% over and above cash rates i.e. 2% pa instead of 1% pa.
If cash interest rates fall to 0.5%pa. You will still be making £2pa on your bond as it is fixed. However the capital (resale) value of your fixed rate bond will have increased. This is because:
Other investors in bonds, due to the bank interest rate being cut to 0.5%pa, may now only want a return on bonds of 1.5%pa (1 % over base rates). Your bond £100 nominal value, paying 2% will then have a equivalent market value higher than you paid because other investors only want a 1.5% pa return on bonds.
Your bond is paying £2pa. Investors looking for a yield now of just 1.5%pa - would pay £133.34 for your bond. Your £100 nominal value bond now has a market value of £133.34.
£2pa (your fixed bond income) divided by new market value £133.34 (that another investor would pay for it) X 100 = 1.5% pa
We have seen base interest rates fall since Brexit. We have seen base interest rates fall even further during the coronavirus pandemic an they could even go negative. The means that fixed rate government bonds, in particular, have increased in market/capital values. Up 33% in the above example of a 0.5%pa rate cut.
We are therefore negative now for fixed rate bond funds as we believe they are at or close to their high point.
Inflation Linked Bonds
Looking to the future, inflation will fall during coronavirus and could go negative initially after coronavirus, with the globe in recession. This is the time to invest in inflation linked funds as their prices are cheaper.
Initially, in a post virus world, the value may fall, but our long term outlook for index linked gilts and bond funds is now positive as we believe inflation will rise, driving demand for index linked stocks.