Positive Sentiment for Fixed Income Funds in 2023

What are Fixed Income Funds?

Governments need to borrow money e.g., to pay for Covid-19 and many larger companies need to borrow money e.g., to buy a new fleet of aircraft.  They usually borrow this money by issuing fixed rate government bonds and corporate bonds.  In the UK, government bonds are known as ‘Gilts’ (gilt edged securities as they are backed by the British Government).  Fixed rate bonds work like an interest only mortgage.  You borrow money, only pay interest on the loan and at the end of the term, the mortgage debt is due to be repaid.  This is broadly like bonds, in that governments or large companies issue bonds, borrow money at a fixed rate and are bonded to pay interest (a coupon) each year and then the capital amount borrowed is paid back at the end of the term.  Many collective pension and investment providers have fixed rate funds that people invest their money in and then the fund manager lends your money to a government or company via their bond issuance.  This usually brings in a stable income stream into the fund and secure investment in that the capital will be repaid at the end of the term.

We have had a negative sentiment towards fixed rate bond funds for a couple of years now but will be looking to go positive or “Green” on our Traffic Light Alert scale in the next few weeks or months.

Values of Fixed Rate Funds can fall as a well as rise.  Why?

Example 1: Impact of Interest Rates Rising

• Investor No.1 invests £100 in a fixed rate bond at 2% pa yield over 25 years.  Bank of England interest rates at the time are 1% pa.  Meaning investor No.1 is getting a ‘premium’ of 1% over interest rates for the bond to receive an income of £2 pa.
• Interest rates then increase to 4% pa, as they look like they will do shortly. 
• A new Investor No.2 now enters the market and has £100 to invest in bonds but to match the 1% premium over interest rates, they want a yield of 5% pa yield (1% premium over interest rates now at 4%). 
• Investor No.2 can either get lend the money to the government if it is prepared to issue new fixed rate bonds at 5% pa or
• If the government is cutting its borrowing and not issuing new bonds at the terms required, Investor No.2 could buy investor No.1’s bond, but the market value of this bond will have fallen due to the interest rate increase:
• Investor No.1’s Bond Face Value is £100 paying 2% i.e., £2 pa.  But to get a return of 5% pa, investor No.2 should only pay £40 market value (for the £100 nominal face value bond) earning £2 meaning investor No.2 achieves a yield return of 5% pa.  (£2pa of £40 paid)
• The market value of investor No1’s bond has fallen in value.

Therefore, when inflation fears abound and interest rates increase, fixed rate bonds have and will fall in value.  Therefore, fixed rate funds have fallen in value over the last couple of years.

Example 2: Impact of Interest Rates Falling

• Investor No.3 invests £100 in a fixed rate bond at 5% pa yield over 25 years.  Bank of England interest rates at the time are 4% pa.  Meaning investor No.3 is getting a ‘premium’ of 1% over interest rates for the bond to receive an income of £5 pa.
• Interest rates then fall to 2% pa, as they look like they may do over the next few years. 
• A new Investor No.4 now enters the market and has £100 to invest in bonds but to match the 1% premium over interest rates, investor No.4 wants a yield of 3% pa yield (1% premium over interest rates now at 2%). 
• Investor No.4 can either lend the money to the government if it is prepared to issue new fixed rate bonds at 3% pa or
• If the government is cutting its borrowing even further as we come out of recession and not issuing new bonds at the terms required, investor No.4 could buy investor No.3’s bond, but the market value of this bond will have risen in value due to the interest rate decrease:
• Investor No.3’s Bond Face Value is £100 paying 5% i.e., £5 pa.  But to get a return of 3% pa, investor No.4 may have to pay £166 market value (for the £100 nominal face value bond) earn £5 pa meaning investor No.4 achieves a yield return of 3% pa.  (£5pa of £166 paid)
• The market value of investor No3’s bond has increased in value.

Therefore, when inflation falls and interest rates fall, fixed rate bonds will likely increase in value as they have before.  Therefore, fixed rate funds will likely grow in value over the next couple of years.

We believe 2023 could be the year to start investing in fixed rate funds again for capital growth, but only after the next interest rate increase, which we hope will be the last and enough to get inflation falling and the economy back on track and progressing towards lower inflation and lower Bank of England interest rates again.

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