ARE UK BONDS ATTRACTIVE?

21.11.2024 With the ink dry on the Rachel Reeves budget, and the winner of the US Presidential election now decided, I take a look at the outlook for UK bonds.

                UK annual Consumer Price Index (CPI) inflation has fallen from a peak of 11.1%, in October 2022, to its current rate of 2.3%. Whilst inflation rates have normalized in most sectors, service sector inflation remains high at 5%. As it is a good indicator of domestically generated inflation it is the key variable that the Bank of England is currently focused on. The outlook for service sector inflation is driven by wage growth. Salary increases should gradually slow as lower job vacancies and lower headline inflation bear down on wage settlements. So, the outlook for UK interest rates is for a gradual reduction with annual CPI inflation around the 2% target.

                In the light of the outlook for inflation and official interest rates UK bonds are currently attractive.  10 year UK government Gilts yield around 4.5% whilst high quality corporate bonds yield over 5%. This represents a 2.5 to 3 percentage point premium to the Bank of England inflation target.

                However, the risks to yields on bonds are on the upside and risks to prices are on the downside. One risk emanates from the additional supply of UK bonds. Currently the UK government is the marginal borrower from the UK bond market. For this financial year it is looking to issue GBP 160 bn of new bonds. This is expected to fall to around GBP 100 bn by the end of the decade. Nevertheless, it would not be a surprise, in a slow growing economy with an ageing population, if the there was some slippage in these projections. This would mean that there was greater supply than expected which would imply lower bond prices.

                Another risk factor for UK bonds is the new administration of Donald Trump. During the campaign he pledged to impose tariffs on foreign goods. If this was enacted it could trigger a global tariff war. In this case it would be likely that Britain would impose retaliatory tariffs against goods from the United States. This would make Britain’s imports more expensive and push up inflation and bond yields.

                So, whilst there are some downside price risks, from extra supply and a tariff war, high quality corporate bonds are currently attractive. On a buy and hold basis they offer interest rates of above 5 percent. This represents a three percentage points premium to the Bank of England inflation target.

For information only. Investors should seek professional advice for their own circumstances before making an investment.

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This post was written by Robin