Bond prices in the UK, US and Germany have fallen sharply, as a rising oil price has fuelled speculation interest rates may rise sooner rather than later. From Laith Khalaf, Senior Analyst, Hargreaves Lansdown.

The recent fall in gilt prices is a warning shot to bond investors. Even though yields are still exceptionally low, they aren’t as low as they were, and that has taken its toll on capital invested at the wrong time. The sell-off is a reminder of the risk of investing in bonds at such low yields. This is heightened by the fact government bonds are seen as safe investments, and consequently feature in many pension funds and supposedly low-risk portfolios.

Meanwhile equities don’t look cheap, but with the possible exception of the US, developed markets don’t look particularly expensive either. However in the light of such low bond yields, equities look attractive by default.’ Bond prices have fallen across the UK, the US and Europe, as investors reassess inflation prospects in light of a higher oil price. As prices have fallen, yields (which move in the opposite direction) have risen.The yield on the 10 year benchmark UK gilt now stands at 1.98 percent, almost 50 percent higher than on 30th January when it stood at 1.33 percent. (Figures based on closing prices on 6th May 2015).The price of this 10 year gilt has fallen by 3 percent since 24th April 2015.  It has fallen 6 percent since its recent peak on 30th January 2015.

This in effect means those who invested on 30th January have seen 1.5 years’ worth of income wiped off the capital value of their investment in three months.

Of course they do not have to sell at this price, they can continue to take their income and wait until maturity, at which point they will get £100 back for each £135 invested, or a 2.6 percent annual capital loss.

This example highlights the perils of investing in bonds at such very low yields. Indeed, yields are still very low; at 1.98 percent the 10 year gilt is still yielding half as much as it was 5 years ago. Oil now stands at $67 a barrel, compared to just over $50 a barrel in January, a rise which has boosted inflation expectations.

As a result the market currently expects UK inflation to average 2.6 percent over the next 5 years, compared to 2.2 percent in January of this year. Higher inflation expectations suggest sooner interest rate rises, which makes the fixed income stream offered by government bonds less attractive, hence prices fall. This is a pretty quick turnaround seeing as not too long ago the market was worried about deflation as a result of a falling oil price, which helped push bond prices up.

Janet Yellen, Chair of the US Federal Reserve, has said that equity valuations are ‘quite high’ and present potential dangers. Here in the UK, the FTSE 100 Index broke through its 1999 high on 24th February 2015 and hit a new record of 7,104 on 27th April 2014. Likewise The Dow Jones hit a record high of 18,289 on 2nd March 2015. However in order to assess how expensive the stock market investors need to look at the price but also at the level of company profits and dividends.

With a dividend yield of over 3 percent, the UK market looks relatively decent value for long term investors, particularly when you compare it to the 2 percent total return you can get from the 10 year gilt. The dividend yield is however variable and not guaranteed, as is any capital invested in the stock market. In terms of company profits, the UK stock market currently stands at a Price/Earnings ratio of 17.8 times earnings compared to a long term average of 14 times earnings, which goes some way to support Janet Yellen’s assertion that stock market valuations are ‘quite high’, though it is by no means strikingly overvalued as it was in 1999, when the P/E ratio stood at 27 times earnings.

Looking at a more long term measure, Cyclically Adjusted P/E (CAPE), the UK stock market stands at 15.7 times earnings, below its long term average of 19.6, suggesting the UK stock market is a bit undervalued. Overall these measures suggest the UK stock market is neither obviously expensive nor clearly cheap, it is somewhere in between.

Options for bond investors

There doesn’t look to be much upside for bond investors for the capital risk they are taking, though bonds still offer diversification benefits for investors. Bond investors have done very well in recent years, even when it seemed they couldn’t rise much further.

However where investors wish to invest in bonds we prefer strategic bond funds, which have the flexibility to invest across the bond spectrum and protect investors from the worst of any sell-off, if the manager gets their calls right of course. Investors might consider Invesco Perpetual Tactical Bond and M&G Optimal Income in this space. Investors simply looking for a conservative fund might consider a total return fund like Newton Real Return, where the manager invests across equities, bonds, commodities and currencies, with a focus on capital preservation.

Income-seekers with a long term view might consider a UK Equity Income fund like Artemis Income (current yield of 3.4 percent) or Threadneedle UK Equity Income (current yield 3.7 percent). A more defensive option is Trojan Income (current yield 3.7 percent). This comes with risks to capital and income, which are variable. Those who cannot stomach any falls whatsoever in the value of their savings should not be invested in bonds, and should simply hold cash, even though it offers a negligible return.