Bond funds sector review – are we near peak interest rates?

Interest rate rises have slowed. Current rates in the UK, US and Europe seem to be near their peak. But government bond yields have continued to rise.

Here’s why and what this could mean for bonds.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, 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. Yields are variable and not a reliable indicator of future income and past performance isn’t a guide to the future.

How have the Investment Association (IA) bond sectors performed over the quarter?

Past performance isn’t a guide to the future. Source: Lipper IM, to 31/10/23.

Government bonds have continued to underperform compared to corporate bonds over the quarter. This has largely been driven by a market acceptance that while interest rates might be near their peak for this cycle, they’re likely to stay at these levels for longer. But it should be remembered, this is only over a relatively short period.

This acceptance has been driven by strong economic data coming out of the US in September, as well as the surprise increase in inflation.

There’s also the challenge of the large amount of government bonds being issued, both here and across the pond.

After significant borrowing to fund the pandemic response and the increased cost of borrowing after rate rises, there are concerns about how many government bonds will need to be issued in the future. This has caused a further fall in prices in recent months, pushing yields up even more.

While these factors have been negative for bond prices, it’s a little reassuring to see things other than inflation and interest rate expectations impacting bond prices.

Is it a sign that bond markets are returning to some sort of normality following what’s been a terrible period since the start of the interest rate rising cycle? Possibly.

Is now the time to buy government bonds?

What are ‘peak rates’ and what do they mean for bonds?

Interest rates go up and down over time, and investors talk about these increases and decreases in cycles. This isn’t just a case of what goes up must come back down though, as there are a lot of variables that impact interest rate levels over time.

We’ve been in a rate rising cycle in the UK since December 2021. At some point, central banks will stop increasing rates. At that point, whatever level interest rates are, that will be the ‘peak rate’ for this cycle.

This matters because interest rate rises have had a negative impact on bond prices. So, once they stop rising, this headwind to bond prices also stops. At that point, bond returns have the potential to go back to being positive. But there are no guarantees.

The Bank of England and the Federal Reserve in the US have both left interest rates unchanged at their last two meetings. That doesn’t mean rates can’t go higher from here, but it at least shows the pace of increases has reduced.

The potential for a shift from an interest rate headwind (rate rises) to an interest rate tailwind (rate cuts) is important for the potential future performance of bonds.

However, it’s unlikely they’ll be cut anytime soon and it’s not at all clear whether they’ll be cut at all. But even if rates just stay as they are, with bond yields at current levels, you’re being paid a reasonable amount to hold bonds.

Where next for interest rates? – 8 things investors need to watch out for

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 past year was Artemis High Income with a return of 6.56%*.

The fund focuses on paying a high income to investors, mainly by investing in bonds. But it can also invest up to a fifth 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 rate rising cycle. The exposure to shares has also been positive over the period.

The fund has the option to use derivatives, which adds risk.

MORE ABOUT ARTEMIS HIGH INCOME, INCLUDING CHARGES

ARTEMIS HIGH INCOME KEY INVESTOR INFORMATION

Past performance isn’t a guide to the future. Source: *Lipper IM, to 31/10/2023.

The worst-performing Wealth Shortlist fixed income fund over the last 12 months was the Legal & General All Stocks Gilt Index fund, returning -5.84% over the period**.

The fund offers a simple way to invest in UK government bonds across all levels of maturity. It can help diversify a portfolio focused on shares or other types of investment.

However, investors should note this concentrated fund only invests in a single, specific, asset class – UK gilts. This can mean the fund itself carries concentration risk as it’s only exposed to one type 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’s also lost value. The fund has continued to meet its objective of tracking the performance of the index well.

Please note charges can be taken from capital, which can increase the yield but reduces the potential for capital growth.

MORE ABOUT LEGAL & GENERAL ALL STOCKS GILT INDEX INCLUDING CHARGES

LEGAL & GENERAL ALL STOCKS GILT INDEX KEY INVESTOR INFORMATION

Past performance isn’t a guide to the future. Source: **Lipper IM, to 31/10/2023.

Fund Insight: our weekly email

Sign up to receive our expert fund research and insights.