Yahoo Finance Are government bonds a good buy when interest rates rise?
What happens to government bond prices when central banks hike interest rates?
If you're interested in buying government bonds, whether it is US treasuries or UK gilts, pay attention to the path of interest rates as any changes usually impact the price.
With many markets volatile to trade, investors often see treasury bonds or gilts as a safer bet and therefore good to include in their portfolio. That’s because they are government-backed and come at a lower risk over other assets, although they are not risk free.
If in doubt about what they are exactly, or how to buy them, take a look at our quick reminders further down.
Impact of interest rates on bonds
The price of bonds reflect a country’s current economic conditions, like the strength of its currency, inflation rate – and of course, interest rate changes carried out by its central bank.
When interest rates rise, the yield, or investment return, on a bond tends to follow suit, but the value of the bond falls.
Read more: How does inflation impact currency pairs, like the USD/GBP?
“When yields fall, the value of a bond rises, so everything hinges on the outlook for interest rates. If rates look set to go higher to combat inflation, yields will stay high and values will still fall. However, if inflation falls and the likelihood of further rate hikes dips, then the opposite will happen,” explains Giles Coghlan, chief market analyst, consulting for HYCM.
Buying bonds when rates are higher
As such, Coghlan said that now could be a good time to buy bonds, as investors could benefit from a high yield in the short-term with rates rising. If inflation continues to fall they can benefit from capital appreciation on their bond investment in the long-term.
“The key risk to this outlook will be if inflation stays higher and that could mean even higher interest rates,” Coghlan added.
Hal Cook, senior investment analyst at Hargreaves Lansdown, reiterated how bonds go down in value when interest rates rise.
"Bond yields need to be higher than bank base rates in order to make them an attractive investment. Bond yields move in the opposite way to bond prices, so if the yield has to increase then the value of the bond has to decrease,” he said.
Impact of upcoming Fed and ECB decisions
The European Central Bank (ECB) and Federal Reserve are both set to announce interest rate decisions with analysts expecting a 25 basis point hike from both.
Matthew Ryan, head of market strategy at global financial services firm Ebury, noted how lower rates lead to lower yields on bonds.
“Should both the Fed and ECB adopt less hawkish stances this week, then we would likely see some downside in UK bond yields, as investors bet that major central banks globally are shifting away from a tightening bias," he said.
"The yield on the two-year gilt has already dropped by around 70 basis points since the early-July peak, as markets revise their estimates for a peak in the Bank of England base rate to 5.75% from 6.5%,” he said.
Laith Khalaf, head of investment analysis at AJ Bell, also commented on the upcoming rate decisions but said they are unlikely to cause much of a stir in bond markets unless they confound firm expectations of a rate hike in each case.
"While inflation is still above target in the US and the eurozone, both central banks will be watching the declining rise in prices and feeling some sense of accomplishment that their tightening cycles is having the desired effect.
“We are therefore entering a period of more nuanced monetary policy where the Fed and ECB are probably more content to let fresh data roll in without pulling the trigger on any further interest rate hikes. We’re not going to see the big shift in bond prices witnessed over the last eighteen months, but price movements there will likely take their lead from economic data points, including the rhetoric coming out of central banks,” Khalaf said.
Portfolio diversification
Analysts also pointed out the importance of portfolio diversification as holding just bonds can be risky in a rate rising environment.
Read more: Interest rates: Why the Bank of England may have to create a recession
Jameel Ahmad, chief analyst at Global Trade Capital (GTC), said: "The UK government has not defaulted on its debt obligations before, which is why purchasing UK government debt can be seen as an interesting option for an investor portfolio during these unusual times."
However, when inflation does start to come down, the Bank of England will be under high pressure from the public to reduce interest rates.
"I would objectively prefer to invest in safe-haven assets such as gold in comparison," Ahmad said.
What are US treasury bonds?
US treasury bonds, also known as T-bonds, are essentially US government debts all wrapped up as an investment, sold to those willing to buy them to finance the country’s spending activity.
In the UK, government-issued bonds are known as gilts.
US treasury bonds are issued for a set term, they pay a fixed interest rate every six months until they mature. However, they can be sold beforehand too.
In addition to treasury bonds, which expire in more than ten years, there are two other types of US bonds, according to their maturity – treasury bills, which expire in less than one year, and treasury notes which expire in one to 10 years.
What are UK gilts?
Gilts are government bonds and the equivalent to US treasury bonds. They are issued by the UK government and in order to finance public spending.
The majority of gilts pay a fixed coupon (generally twice a year) and mature at a set date. The maturity of the asset varies from a few months to over forty years, which is listed in the ticker name.
How do you buy bonds?
Bonds can be purchased from a bond broker, similar to how stocks can be purchased from a stockbroker. This can also be done online through a trading platform.
Bonds can also be purchased directly through banks and government-sponsored websites. UK gilts can also be bought through the UK Debt Management Office's purchase and sale service.
Another way to gain exposure to bonds would be to invest in a bond fund (a mutual fund or exchange-traded fund) that exclusively holds bonds in its portfolio.
Through a trading platform, there is also the option to trade on changes in bond prices using CFDs - a type of leveraged derivative. This means that, when trading, you won't take ownership of an actual bond but you will take a position on the bond futures market either rising or falling in value.
The profit or loss will then depend on whether you correctly predicted the direction of movement, how much the market moved, and the size of your position.
How much investments are in bonds?
In 2022, the global bond market totalled $133tn (£103tn), according to data from Visual Capitalist.
Valued at over $51tn, it said the US had the largest bond market globally. Moreover, government bonds made up the majority of its debt market, with over $26tn in securities outstanding. In 2022, the Federal government paid $534bn in interest on this debt.
China was second, at 16% of the global total with local commercial banks holding the greatest share of its outstanding bonds.
The Visual Capitalist data also showed that in Europe, France was home to the largest bond market at $4.4 trn in total debt, surpassing the UK by roughly $150bn.
Pension fund holdings in government bonds
The other thing to remember is that if you have a pension fund, many portfolio managers include government bonds, along with other assets.
The pension market in the UK, for example, has expanded to become the largest in Europe, worth over £2.5 trillion in 2021, according to ONS figures.
Whilst bonds are often seen as a safer investment, as earlier noted, they are not risk free, hence why portfolio diversification is always advised.
Watch: Why inflation could tick higher
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