Could government bonds offer a solution to low deposit rates?

They’re tax free, are yielding about 3 per cent and are a relatively safe investment when compared with equities. So what’s not to love about government bonds?

While the National Treasury Management Agency (NTMA) continues to pay Irish savers paltry amounts via the State Savings scheme, institutional investors are faring a lot better with government bonds. Last March, for example, the NTMA sold €800 million of bonds that are due to mature in 2037 at a yield – or interest rate – of 3.37 per cent.

This was the highest rate paid to investors since the NTMA sold 10-year bonds a rate of 3.54 per cent back in 2014, and is a reflection of the higher interest rate environment across the euro zone. Contrast this with the highest rate available through the State Savings scheme – of just 1.5 per cent a year, locked away for 10 years.

But government bonds are not just for institutional investors – retail investors can also buy.

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So if you’re looking for a higher return on your money, what do you need to know before you allocate? And if bonds aren’t for you, could money market funds offer an alternative?

Government bonds

Unlike US retail investors who are regular investors in US treasury bills, Irish savers and investors are not as au fait with Irish government issued debt.

As David Quinn, managing director of Investwise Financial Planning, notes, when Irish government bonds were paying about 14 per cent back in 2010, Irish savers were still “clamouring for bank deposits at 5 per cent”.

It’s not that smaller savers can’t buy government bonds: it’s more that they tend to be acquired by institutional investors.

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This is for a number of reasons. At the outset, when government bonds are sold for the first time for example, they are restricted to institutional buyers. Subsequently stock exchange charges will apply when buying bonds, and it’s also most efficient to buy bonds in large chunks. And bonds have offered a poor return in recent years.

But the tide is starting to turn.

“It’s something we’re seeing more interest in,” says Elizabeth Geoghegan, head of fixed income strategy with Goodbody, adding that there have been big retail flows in the market in general into government bonds.

“For investors willing to take a little bit more risk, there’s definitely a lot more on offer today in terms of yield, relative to what you were seeing even 12 months ago. And bonds are really at the centre of that,” she says, adding that they’ve almost experienced a “revival” in the last while.

To get a reasonable price on the market and trade them efficiently, in our experience the transactions need to be more than €250,000

—  David Quinn, managing director of Investwise Financial Planning

“Eighteen months ago, if you were investing in short-dated government bonds, you were looking at negative yields,” she says. Now, that same kind of instrument could be yielding up to 3 per cent.

While there is typically no minimum trade on a government bond, Quinn says they tend to trade in big lots. So, while you can invest from amounts as low as several thousand euro, given costs involved etc, Quinn suggests a much higher investment. “To get a reasonable price on the market and trade them efficiently, in our experience the transactions need to be more than €250,000,” he says.

They can be a useful structure for people who have a sizeable lump-sum and who don’t need immediate access to the money. Quinn says it may be possible – but isn’t always that easy – to time the maturity of the bond with when the person needs access to the capital.

The risk

Remember, bonds are not the same as deposits; they do carry a greater risk.

When buying government bonds, your main risk is related to the chance of default by the relevant government. Of course, if that happens with a core euro zone economy, you might have bigger problems than just your bond portfolio.

Ireland is currently rated AA-; Aa3 and AA- by S&P, Moody’s and Fitch, respectively. This puts it at “high medium investment grade”, just below AAA ratings.

Bond prices have an inverse relationship with interest rates, so as interest rates rise, bond prices fall

The second, and more pertinent risk, perhaps, is that if you can’t hold your bonds until maturity, and have to sell, you may incur a loss.

“The price will go on a journey from buying today to when it matures, and sometimes along the journey you can make gains and losses,” says Geoghegan.

Bond prices have an inverse relationship with interest rates, so as interest rates rise, bond prices fall. This could mean you will be facing a loss should you have to sell out in advance of the redemption date.

However, different bonds have different levels of sensitivity to interest rates, largely due to the maturity of the bonds.

“Last year as interest rates rose, bond prices fell across the board, but what you saw was that bonds that had a longer maturity fell more than bonds that were of a shorter maturity,” says Geoghegan.

Due to the unique backdrop of bond markets today, shorter duration bonds are offering a higher yield relative to longer dated bonds. It present a possible opportunity.

“We’re actually seeing bonds with shorter duration and less interest rate risk, offering you better yields than longer dated bonds,” says Geoghegan.

Taxation

As well being very liquid, another advantage of Irish government bonds is that, for Irish resident savers and investors, they are tax free. This means that if you’re an Irish resident, you won’t have to pay any capital gains tax (CGT) when you sell, or redeem, an Irish government bond.

You must however, pay tax on any interest earned at your marginal rate of tax. This may be at a higher rate than the 33 per cent CGT rate, given a higher income tax rate of 40 per cent. It is also higher than Dirt charged on deposits, which is also 33 per cent.

If your strategy is to hold the bond until maturity and make a tax free gain, you could look out for a zero coupon bond. These do not pay interest; instead they trade at a discount, as the interest is factored into the payout at maturity. So, you might buy the bond at a discount, but when it’s redeemed at maturity, it is at its full face value – and the gains are tax free.

However, as Geoghegan notes, there currently aren’t any zero coupon Irish bonds of short duration available.

“So you have to take on additional duration risk in trying to look for zero coupon bonds,” she says, adding that, in any case, you should be looking for an investment that is aligned with your own investment and financial objectives first and foremost, not driven by tax views.

Cost

Another downside of investing in government bonds is the expense incurred in acquiring such investments. You’ll have to pay stockbroking charges to buy bonds plus an account fee to hold them in a nominee account.

Davy for example, charges commission of 0.5 per cent of the transaction value on government bonds, subject to a minimum of €100 – so a €100,000 trade would cost €500. At Goodbody, you’ll pay commission of 1 per cent on trades of up to €25,000, and 0.5 per cent on the balance (subject to minimum charge of €25). Cantor has a 0.5 per cent commission charge on fixed income securities, with a minimum fee of €55.

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Account fees will also apply – it’s €100 at Goodbody for example, and there will be a further commission charge if you sell the bond during the term, but not if you hold it until maturity.

Money market funds

Another option for those searching for yield could be money market funds. “These are cash funds that use international bank deposits and are accessible to retail investors,” Quinn says.

At the moment, many of these are yielding around the same as government bonds, at around 3 per cent, and Quinn cites the JP Morgan EUR Standard Money Market VNAV Fund as an example. As of May 15th, the fund, which is invested in certificates of deposit, commercial paper and treasury debt, among other cash type instruments, was yielding 3.14 per cent. It has an annual charge of just 0.1 per cent.

Money market eturns tend to be ‘stable’, says Quinn, but remember, unlike deposits, they’re not guaranteed – and you might lose some of your money

While the fund prospectus states a minimum investment of €100 million, this doesn’t apply when buying it through a retail platform.

Like a listed fund, you buy a money-market fund through a stockbroker, or funds platform such as Davy Select.

Returns tend to be “stable”, says Quinn, but remember, unlike deposits, they’re not guaranteed – and you might lose some of your money. Risks to money market funds include interest rates falling and difficulties with the underlying assets. Back in 2008, a US money market fund ran into difficulty when Lehman Brothers collapsed, as it held commercial paper issued by the bank.

When it comes to tax, as a fund, gains on money market funds will be subject to exit tax at 41 per cent. Some such funds pay out the interest every year while others roll it in.