The UK represents an alternative for many investors. No longer in the European Union, with its own currency and still one of the largest economies in the world, investing in UK bonds, also known as Gilts, can add diversification to our portfolio.
- Reasons for investing in UK Bonds
- Risks of investing in UK Bonds
- How to invest in UK Bonds
The interest rate hikes of 2022 and 2023 have made bonds significantly more attractive. After almost 15 years of extremely low or even negative interest rates in many countries, bonds are once again offering positive returns to investors.
In such a scenario, investors can choose from many different types of bonds. The main categories of bonds are sovereign and corporate.
Sovereign bonds do not usually have any credit risk, but offer lower yields. Corporate bonds are very heterogeneous, but they tend to have higher credit risk and, as compensation for that, offer higher potential returns.
The exception to this generalization are sovereign bonds issued by countries that do not control the currency in which they issue debt. Examples would be Spain or Italy in the Eurozone, or Mexico issuing bonds in US dollars. These bonds can be considered a hybrid between traditional sovereign bonds and corporate bonds, from a credit risk perspective.
The other very important thing to consider when investing in bonds is the currency. One option is to only invest in bonds denominated in our own currency. For example, for investors whose domestic currency is the euro, German bonds are an alternative without credit risk or currency risk.
But it is also possible to invest in bonds of other currencies. An example would be U.S. Treasuries, denominated in US dollars.
In the next few sections, we will talk about another option for those interested in investing in bonds from other regions and denominated in other currencies. We will focus on UK government bonds, some arguments in favor of them, the potential risks we should consider and how to carry out such an investment.
Reasons for investing in UK Bonds
Let us look at the two main reasons for investing in UK bonds:
Despite being considered safe, investing in bonds carries risks. Even if we only invest in sovereign bonds without any credit risk, there are other risks to consider. All investments are subject to risk.
For this reason, it is advisable to have a certain degree of diversification in our portfolio. We can diversify in many different ways. We can invest in different types of assets, such as stocks, bonds and gold. And within each of these asset classes, we can pick assets with different characteristics.
For those investors who own bonds in their portfolio, investing in UK bonds can add diversification. These can be combined with bonds denominated in euros and dollars, so that we can benefit from currency and interest rate dynamics in several regions at the same time.
Despite facing certain challenges, the British economy remains one of the largest in the world and is outside the European Union. That represents economic and political diversification relative to investments inside the UK.
At the same time, the UK has its own currency, the British pound. As a result, UK bonds offer currency diversification relative to most assets we own in our portfolio.
Given all of this, there is no doubt that investing in British bonds can boost the international diversification of our investment portfolio.
Higher interest rates
Compared to other European currencies, such as the euro, the Swiss franc or the Swedish krona, the pound sterling always tends to have higher interest rates. That makes British bonds somewhat more attractive to European investors. We can view these higher interests as compensation for taking on the additional currency risk.
While the spread between interest rates in the UK and interest rates in the euro area fluctuates over time, in most situations it is between 1 and 1.5%.
This means that holding UK bonds in our portfolio will help us generate more interest income compared to what we would get by investing only in German or US government bonds.
One of the positive aspects of the United Kingdom as a country and economy in which to invest is that its population is younger than that of most other Western countries.
As a result, it is feasible to expect higher rates of economic growth in the United Kingdom than in other European countries, such as Germany, where the population is older and already declining in numbers.
A younger population makes it possible for the government to finance its operations by collecting taxes, making central bank intervention less necessary to finance government deficits.
Because such interventions by the central bank tend to devalue the currency, this would indicate to us that the risk of debasement of the pound by the Bank of England, the central bank in the United Kingdom, is smaller than the risk of devaluation of other currencies, such as the euro, by their central banks.
Risks of investing in UK Bonds
While there are reasons to invest in them, UK bonds also expose us to a number of risks that must be considered:
The most obvious risk is that these bonds are denominated in a currency other than our domestic currency. Because exchange rates between currencies fluctuate constantly, we may buy pound-denominated assets at an exchange rate, and see that exchange rate move against us later. Such fluctuations would cause losses in our investments.
However, it should be noted that the exchange rate can also move in our favor. Thus, if the pound sterling appreciates against our domestic currency, be it the euro, the US Dollar or the Mexican peso, we would be generating additional return.
For those who want to invest in British bonds without having to take on any currency risk, it is possible to do so through investment funds that use derivative contracts to hedge that risk. If you want to learn about how such derivatives work, check out this link.
When we invest in bonds, we exchange our money today in exchange for money in the future. The nominal amount that we will receive in the future is fixed in most cases, as it depends on the interest coupon of the bonds we buy.
As a result, one of the biggest risks of investing in bonds is high inflation. Inflation risk exists regardless of the currency in which our bonds are denominated and should always be taken into account.
Therefore, if we invest in British bonds, we want inflation in the United Kingdom to remain as low as possible. That will ensure that the pound sterling does not lose much value and that our interest income can generate additional purchasing power for us.
For those who do not want to take on any inflation risk, it is possible to invest in inflation-linked bonds. The British government issues these types of bonds.
In this case, our initial investment will always grow in line with the official inflation rate in the United Kingdom. However, it is important to note that we will receive a lower rate of interest. If you want to learn about inflation-linked bonds, check out this post.
Increasing interest rates
Finally, it is worth noting that the potential of higher interest rates in the future is another source of risk for bonds, particularly when maturities are far into the future. This is known as interest rate risk.
Because old bonds pay lower interest rates, the only way for them to offer a similar return as new bonds with higher coupon rates is through lower prices. When bonds get cheaper, they offer higher yields. This is because we must pay less money today to receive the same amount of money in the future.
Obviously, the price of our bonds is irrelevant if we plan to hold the bonds until maturity. This is usually the case if we buy short-maturity bonds.
However, if we own bonds that mature several decades from now, we will most likely want to sell them sometime before maturity. In such a situation, the price would be important. And the farther the maturity of the bond, the more its price will fall if interest rates rise.
By the same token, however, the relationship between interest rates and bond prices also applies when interest rates fall. Therefore, if we have invested in British bonds and interest rates decline in the United Kingdom, our bonds will rise in price.
How to invest in UK Bonds
For those interested in investing in UK bonds, let us look at the two main ways to do so:
One of the easiest ways to invest in British bonds is by buying such bonds individually. To do this, we only need to have access to a broker that allows us to invest in individual bonds.
One option is Interactive Brokers. Regardless of which broker we use, we can look for bonds that look interesting to us, decide what price we are willing to pay for them, and put in a market order. Once we have purchased the bond, we will receive interest income on a regular basis. Until the bond matures or we decide to sell it.
Although investing in individual bonds can be complex for some investors, it is also the way that offers us the most flexibility.
UK Bond ETF
The other option we have to invest in this type of bonds, and undoubtedly the most convenient, is through a UK bond ETF.
ETFs, or exchange-traded funds, trade in the same way as stocks. They can be bought and sold quickly and easily, and we can carry out investments with small amounts of money.
There are several fund management firms that offer British bond ETFs. This means we can choose exactly what kind of bonds we are interested in buying. For example, we can focus on bond ETFs of short maturities or long maturities.
If you are interested in checking out what funds are available at your broker, it is essential to be familiar with the word Gilt. Bonds issued by the British government are known in the financial markets as Gilts. Hence, it is very common to find this word in the name of the ETFs that own these bonds.
Additionally, if you do not want to take any currency risk, you can look for an ETF hedging this risk. For example, you can take a look at the U.K. Gilt UCITS ETF – EUR Hedged fund, managed by Vanguard. It hedges all currency risk for investors whose domestic currency is the euro.
Los bonos pueden ser activos muy útiles para aquellos inversores que deseen tener una cartera diversificada, capaz de sobrevivir cualquier tipo de situación macroeconómica.
Poseer bonos es especialmente rentable en tiempos de crisis económica, cuando hay una recesión, o cuando se produce un shock deflacionario en la economía, debido a que los bancos están menos dispuestos a prestar dinero a empresas y familias.
Dentro de nuestros bonos, es a menudo aconsejable tener una selección variada. Si bien los bonos británicos no son uno de los activos principales, sí pueden ser un buen instrumento para complementar nuestra cartera de inversión.
Los bonos del Reino Unido ofrecen intereses superiores a los de la zona euro, acarrean ciertos riesgos y también ofrecen ciertas ventajas. Poner nuestro dinero en ese mercado es fácil y al alcance de prácticamente todos los inversores.
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