The bond bubble

I am a sterling investor and was surprised to see the UK increase interest rates last week, which goes against the decision to cut interest rates severely over the past few years. Because of low interest rates, I have invested into sterling-denominated bond funds. Is this still advisable if interest rates continue to rise? I received a valuation statement from one of the funds I have and the capital value had dropped about 5% over the last quarter.

The Bank of England raised interest rates to 3.75% last week - the first rise since February 2000 when rates rose from 5.75% to 6.00%. Since then, however, there have been nine rate cuts before last week's rise. For savers, this was of course good news, although it is my opinion that rates should not have been cut back in July and the recent increase was simply a reversal of the earlier decision.

This increase has been justified also by continuing signs of a solid recovery in the UK economy, which is evidenced in the turnaround in the UK stock market with very healthy returns over the past seven months. Coupled to that is the need for consumer spending to be controlled as well as a steadying of house prices, which have been escalating out of all proportion for a number of years. Such spending and house inflation can be reduced by a careful management of interest rate increases.

Going forward, I would not be surprised to see further rises in interest rates throughout next year, with rates in the region of 4.5% by the end of 2004. This view is of course a personal one, but a continuing expansion of the UK economy at the level we have seen over the past two quarters would merit further interest rate hikes on a gradual basis.

If this is the case, then that will potentially be bad news for sterling-denominated bond holders, especially those that invest in Gilts and AAA rated bonds. While such funds appear to offer security by way of an unlikely default, such high rated bonds are extremely sensitive to interest rate movements.

As interest rates rise, the fixed coupon that bonds offer becomes less attractive to new investors so their capital value will fall. For example, if interest rates were to rise by 1% over the next 12 months then high rated bond funds could fall in value in the region of 5%.

If you are a fixed interest/bond investor, then you must be aware of the importance that interest rates play - even for the highest quality bond funds. It is important therefore to consider lower rated bonds (where appropriate) as they are not so sensitive to interest rate movements.

They do however carry a higher risk of default. One should also look to global bonds, i.e. bonds of other currencies that will have little or no correlation to UK interest rates.

In summary, bond investors must monitor future interest rate movements very carefully as one cannot expect the same returns witnessed in sterling bond funds over the past three years going forward. This is based on the assumption that interest rates will increase, which is the opinion of most analysts at present.

Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2137-8627/9984-2614 (office hours) or e-mail mhollingsworth@waldonet.net.mt.

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Malta exchange control regulations must be observed. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.