Making better use of bonds

Inflation has dropped to its lowest levels since modern records began in 1989, according to official measures of the Consumer Price Index released last week. Prices increased by just 0.3% in the 12 months to January. And with inflation so subdued, the prospect of interest rate rises becomes ever more distant.

It now seems increasingly unlikely that interest rates will budge from their current record low any time soon. In a recent interview, Mark Carney, Governor of the Bank of England, made clear that if wage growth is knocked off course by falling prices, further rate cuts could follow. Although most economists (myself included) think that the dip in inflation is a result of falling food and oil prices, and will reverse into next year, even in this scenario rate interest rates are expected to rise very gradually. The Bank of England’s own forecasts expect rates to be at just 1.5% in 2020 – still very low by historical standards.

Low interest rates have clobbered savers over the past seven years, and will continue to do so while this situation persists. In Savings in the Balance, a report we published last December, the SMF argued that savers must adapt to this new low-interest world. If we are to save enough to support ourselves through longer lives, we will need to become braver about seeking higher returns.

The UK’s retail bond market, which recently celebrated its fifth birthday, is one platform through which savers can earn higher returns, without exposing themselves to the risk involved in directly investing in a company by buying shares. For would-be investors who are concerned about volatility in markets, bonds offer a relatively attractive option.

Yet, at present, they are underused. Compared to Italy or Germany, where bonds are commonly held by household investors, barely 1% of people in the UK own either corporate or government bonds. Given that they are currently offering returns of 5-6%, for many savers this is a lost opportunity.

So why aren’t more savers taking advantage of these investment opportunities? Part of the problem seems to be perception of risk: individuals face substantial barriers when trying to invest and often have to overcome their inherent tendency to loss aversion – they would rather not make any gain than risk a loss. How can they overcome this to access higher returns?

In a consumer survey undertaken specially for Savings in the Balance, we found that the way a product is labelled affects the consumer’s perception of the risk involved. So, for example, a pension was seen as being less risky than an investment fund, although in reality they are very similar products. Even starker, a stocks and shares ISA was perceived as less risky than buying shares, although the underlying products are identical – the only difference is the tax treatment.

In Savings in the Balance, we argue that a further £2,000 ISA allowance specifically for bonds could help to increase use of these instruments. While steps could also be taken to make retail bonds more attractive to corporate issuers, the creation of an ISA allowance could help to spur the creation of corporate bond funds aimed at retail investors, and the greater demand unlocked here could help encourage firms to tap into this market.

There is no getting around the fact that another tax allowance for savers would provide an additional advantage to those with relatively high incomes or savings already. However we believe that in this case, this disadvantage is outweighed by the potential benefits of bringing more savers away from low-return products, and into bond markets where their cash can feed firms and stimulate the growth of the economy. The retail bond market could be a boon for British savers and firms alike but, five years in, there is still some growing to do.


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