As interest rates potentially peak, investment advisors say there are now opportunities for hefty gains through certain government bonds. The prices of long-dated bonds issued during the era of low-interest rates have slid as yields soared over the past year. Bond prices move inversely to yields. But when central banks cut interest rates — as market watchers expect will happen in the next 12 months — due to a recession or falling inflation, yields will likely fall and bond prices will get a boost. To give an example, U.K. government bonds maturing in 2061 were issued in May 2020 with a coupon (regular payout) of 0.5%. This was during the Covid-19 pandemic when the Bank of England had just cut rates to 0.1%. However, the rise in the central bank’s key interest rate to 5.25% over the past year means the bond’s cash price has now fallen below 30 pence to the pound to compensate for yields at 4.5%. “Absolutely, this looks attractive: 30 pence in the pound,” said Matthew Amis, investment director for fixed income at Abrdn, referring to U.K. government bonds (also known as gilts) with the identifier ISIN GB00BMBL1D50. “If and when we get to the [interest rate] cutting cycle, the price of this dip, is more heavily felt in this low coupon bond than a gilt that has a higher coupon.” “You potentially could make a good capital appreciation when interest rates start to fall,” Amis added. The phenomenon can also be seen in certain 30-year U.S. government bonds issued during the pandemic. For instance, the U.S. Treasury bond with the identifier CUSIP 912810SP4 maturing in 2050 has fallen in price to 48 cents to the dollar to compensate for its low 1.375% coupon, as yields rose to 4.76%. U.K. investors get an extra benefit, however, as capital gains in the country’s government bonds are tax-exempt and so would increase the total returns. US30Y 5Y mountain When will bond prices rise, and by how much? Bond prices are sensitive to interest rates and inflation expectations. Amis expects the Bank of England to cut interest rates by 0.25 percentage points in August 2024. The bond specialist also expects a “steady decline” in base rates to about 3.5%. “That would be the kind of base case and the good scenario for the Bank of England,” he said. When interest rates were at 3.5% in December 2022, the long-dated bond with a low coupon had a cash price of about 40 pence to the pound, 40% higher than its current price of 27 pence. As such, if rates fall to this level again, investors who bought the bond at its current level could be looking at a 40% gain in price. Asset manager Abrdn also expects annual U.K. GDP growth to remain nearly flat next year, with inflation falling to 2.4%, near the Bank of England’s target. Iain Stealey, international CIO for fixed income at JPMorgan Asset Management, agreed with the basis of the long-duration bond trade and said he was also expecting the Bank of England to cut interest rates next year. Stealey believes that since monetary policy acts with a lag, the U.K. economy is yet to feel the full effect of the hike in interest rates. “Wages are still going up, but the jobs market does seem to be loosening,” Stealey said, referring to the rise in unemployment, which could lower wage pressures and subside inflation and interest rate expectations. Meanwhile, interest rate traders in the U.S. expect the Federal Reserve to implement its first rate cut in July 2024.
Expecting a recession? Advisors say you could make 40% returns with a simple bond trade
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