What the UK interest rate rise means for bonds

The Bank of England’s decision to raise interest rates by 0.25% to 0.5% on 2 November has been dubbed a turning point for UK monetary policy by some commentators.

The rise is significant because it marks the first interest rate hike in a decade. However, it should also be put into context: we are simply back to where we were prior to the European Union referendum last June. We’ve moved from the ’emergency, emergency’ level of 0.25% back to ’emergency’ levels of 0.5%.

It has, however, left some investors concerned about what this means for their bond portfolios. Loose monetary policy – namely, low interest rates and quantitative easing (QE) – has driven the performance of bond markets across the globe over the past decade. This means that policy tightening – rising interest rates and unwinding QE – is likely to have repercussions for your investments.

Bonds can be particularly sensitive to interest rate changes. Low interest rates and central bank bond-buying activity (quantitative easing or ‘QE’) has caused government bond prices to rise and yields to fall (as the two move inversely to each other). If interest rates are now rising, yields could increase, but the price of bonds could fall, resulting in capital losses.

However, the global policy of rate ‘normalisation’ can only really be described as glacial. Mapping out the potential course ahead, Bank of England governor Mark Carney said another two rate rises may be required over the next three years to control inflation, which would take us to a base rate of 1% by 2020 – still a long way off the long-term average.

On the other side of the pond, the US Federal Reserve has raised interest rates four times since the financial crisis and plans to introduce more over the coming months. It is also preparing to sell back some of the assets it previously bought as part of its QE programme.

The European Central Bank (ECB) sits on the other side of the scale: it is slowing down the pace of its bond-buying programme and only expects to raise rates in 2019.

Bonds have historically been a good diversifier and source of income within portfolios. Today, we think they still deserve a place in portfolios; the key is to back bond fund managers with the flexibility to invest across different parts of the market. We would expect experienced strategic bond managers to identify opportunities in fixed income, regardless of what happens to interest rates.

Elite Rated Jupiter Strategic Bond is a top pick in this space. Manager Ariel has demonstrated an aptitude for reading the economic cycle. Combined with solid bond selection, he has achieved impressive risk-adjusted returns over the years.

This fund can be complemented by the Elite Rated Baillie Gifford Corporate Bond fund. In spite of its name, we classify it as a strategic bond fund because it invests across the investment grade and high yield markets.

We like that managers Stephen Rodger and Torcail Stewart undertake in-depth research on the underlying bonds. Unlike other teams in the sector, they do not aggressively manage the interest rate exposure or distribution between the credit quality of underlying bonds. It is an approach that has paid off over the years.

For investors who don’t wish to take on interest rate risk – known as ‘duration’ – within their portfolio, the Elite Rated AXA Sterling Credit Short Duration Bond fund is a good option. Manager Nicolas Trindade does this by investing in high quality corporate bonds with expected maturities of less than five years.

Bonds still warrant a place in your portfolio. I would suggest thinking carefully about the funds which have the potential to perform well – whatever central banks throw at them.