Interest rates have continued to rise, with the US interest rate now at its highest level in 22 years. At the same time, inflation has fallen. All the while, the talk of central bankers is about long and variable lags.
So, what has this all meant for bonds?
This article isn’t personal advice. If you’re not sure whether an investment is right for you, please ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest. Past performance isn’t a guide to the future.
What’s the latest on interest rates and inflation?
Interest rates and inflation have been key reasons behind the losses in bond markets over the last 18 months or so. The trend over the last three months has been no different, so where are we now?
Over the quarter, central banks in the UK, US and Europe all raised interest rates further and inflation has come down across the board.
Comparative interest rates in different regions
| Region | Interest rate at 30 April 2023 | Interest rate at 31 July 2023 | Inflation at 30 April 2023 | Inflation at 31 July 2023 |
|---|---|---|---|---|
| UK | 4.25% | 5.00% | 8.70% | 6.80% |
| US | 5.00% | 5.50% | 4.90% | 3.20% |
| Eurozone | 3.00% | 3.75% | 7.00% | 5.30% |
Interest rate increases have continued to act as a headwind for bonds. While inflation falling is a positive, bond investors have been expecting inflation to drop and so the impact on bond prices has been limited.
How have the Investment Association (IA) bond sectors performed over the quarter?
Chart showing recent bond sector peformance
Annual IA Sector Percentage Growth
| July 18 – July 19 | July 19 – July 20 | July 20 – July 21 | July 21 – July 22 | July 22 – July 23 | |
|---|---|---|---|---|---|
| IA UK Gilt TR | 7.10% | 10.50% | -4.62% | -14.58% | -15.73% |
| IA £ Corporate Bond TR | 7.08% | 5.87% | 2.88% | -11.46% | -5.86% |
| IA £ High Yield TR | 4.72% | -0.16% | 10.70% | -8.83% | 4.10% |
| IA £ Strategic Bond TR | 5.59% | 4.00% | 5.53% | -8.95% | -1.66% |
Past performance isn’t a guide to the future. Source: Lipper IM, 31/07/23.
This is a similar performance pattern to the last 18 months. High yield bonds have performed better due to higher interest payments offsetting the losses caused by rising interest rates.
They also typically have lower duration compared to other areas of the bond market like government or investment grade corporate bonds.
Duration measures how sensitive a bond is to interest rate changes. A lower figure means the bond is less sensitive than a higher figure. As interest rates rise, bond values typically fall. Having a lower duration position has helped keep losses smaller than other areas of the bond market.
Long and variable lags
Anyone who’s been listening to central banks in 2023 will have heard the phrase ‘long and variable lags’ on many occasions. Why? Because it’s a common expression used to describe how changes in interest rates impact the economy.
The logic is that changing the interest rate for an economy doesn’t immediately change the amount of money that people and businesses have to spend. Therefore, in the short term, they are likely to continue to spend as they were before the change in interest rates.
However, over time, the impacts of changes to interest rates do kick in and spending changes. This in turn impacts economic activity.
Let’s take the example of increasing interest rates on individuals.
Eventually your mortgage will come up for renewal, or you’ll need a new loan for a car. Interest rates have risen so much that starting a fixed rate savings account now might be very appealing. All of these things would reduce the money you either have to spend or choose to spend.
When this happens to lots of people at the same time, this reduces spending across the board, which reduces economic activity. The same logic applies to businesses.
There is a double whammy when the cause of increasing interest rates is inflation. After a period of high inflation, everything costs more than it did before. So even if the amount of money spent is the same, it buys fewer goods and services.
The biggest challenge with this theory is answering the question – how long does it take for changes to interest rates to impact the spending behaviour of people and businesses?
The theory of long and variable lags is credited to Milton Friedman in the late 1950s, who suggested the time period (the lag) between changing interest rates and the impact on spending could be anywhere from four to 29 months (is variable and sometimes long).
Since then, there’s been a lot of academic research on this topic and no one can give a definitive answer. Even Jerome Powell, Federal Reserve Chairman, when talking about long and variable lags in November 2022, noted that “the truth is, we don’t have a lot of data and it’s highly uncertain”.
Why does this matter today?
Well, while it feels like this interest rate rising cycle has been going on forever, the US Federal Reserve only started raising interest rates in March 2022. If we estimate that it takes 12 months for the impact of these increases to be felt, that means that all of the interest rate increases since July 2022 have not yet been felt by the economy. The US interest rate in July 2022 was 2.5%. It’s 5.5% today.
The theory of long and variable lags therefore suggests that there are still plenty of reductions in spending to come.
How have our fixed income Wealth Shortlist funds performed?
Our Wealth Shortlist bond funds have delivered mixed performance over the past year. Some have outperformed their peer group, while others have underperformed.
We wouldn’t expect them all to perform in the same way though. If all your funds in a sector are performing well at the same time, they're probably investing in similar areas.
Investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a long-term diversified portfolio.
For more details on each fund and its risks including charges, see the links to their factsheets and key investor information below.
The best performing Wealth Shortlist fixed income fund over the last year was Artemis High Income with a return of 3.64%*. Past performance isn’t a guide to the future.
The fund focuses on paying a high income to investors, mainly by investing in bonds, but it can also invest up to 20% of its assets in UK and European shares.
A focus on high-yield bonds and exposure to shares that pay a dividend makes it a little different from most bond funds, though it also makes it a higher-risk option.
The focus on high-yield bonds has been a positive over the last 12 months, with that area of the fixed interest market typically performing better during this interest rate rising cycle. The exposure to shares has also been a positive over the period.
The fund has the option to use derivatives, which adds risk.
Annual percentage growth
| July 18 – July 19 | July 19 – July 20 | July 20 – July 21 | July 21 – July 22 | July 22 – July 23 | |
|---|---|---|---|---|---|
| Artemis High Income | 2.06% | -1.86% | 13.19% | -8.38% | 3.64% |
| IA £ Strategic Bond | 5.59% | 4.00% | 5.53% | -8.95% | -1.66% |
Past performance isn’t a guide to the future. Source: *Lipper IM, to 31/07/2023.
MORE ABOUT ARTEMIS HIGH INCOME, INCLUDING CHARGES
ARTEMIS HIGH INCOME KEY INVESTOR INFORMATION
The worst-performing Wealth Shortlist fixed income fund over the last 12 months was the Legal & General All Stocks Gilt Index fund, returning -15.20% over the period**. As always, past performance isn’t a guide to the future.
The fund offers a simple way to invest in UK government bonds across all maturities. It can help diversify a portfolio focused on shares or other types of investment.
Inflation and rate rises have resulted in UK government bonds losing money over the period. As this is a passive fund that tracks the index, it has therefore also lost value. The fund continues to meet its objective of tracking the performance of the index well.
Annual percentage growth
| July 18 – July 19 | July 19 – July 20 | July 20 – July 21 | July 21 – July 22 | July 22 – July 23 | |
|---|---|---|---|---|---|
| Legal & General All Stocks Gilt Index | 6.67% | 10.05% | -4.38% | -14.41% | -15.20% |
| IA UK Gilt | 7.10% | 10.50% | -4.62% | -14.58% | -15.73% |
Past performance isn’t a guide to the future. Source: **Lipper IM, to 31/07/2023.
MORE ABOUT LEGAL & GENERAL ALL STOCKS GILT INDEX INCLUDING CHARGES
LEGAL & GENERAL ALL STOCKS GILT INDEX KEY INVESTOR INFORMATION
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Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.