Is there still shelter in bonds?

Ed Monk
Ed Monk
Fidelity Personal Investing2 February 2018

Prices of benchmark US government bonds have fallen for the second day in a row, pushing yields to a level not seen for almost four years.

10-year Treasury yields climbed to 2.8% today, the highest since April 2014. Bond yields rise automatically when bond prices fall.

It will add to the feeling that we are close to an end of, not only the bond market strength that has been evident since the financial crisis, but perhaps even the 30-year bull market for bonds - yields have been on a general downward trajectory since the early 1980s.

The case is not hard to make. Bond prices fall when interest rates and inflation rise, as they have been doing in the US. Inflation eats away at the value of the cash return a bond pays, so buyers likely won’t buy unless the price falls to a point where the yield provides adequate compensation for this. Meanwhile, higher interest rates increase the return on risk-free cash, meaning bond prices have to fall to make the income they pay an adequate reward for the extra risk being taken.

The news this week that the US Federal Reserve, while not raising rates this time, seems very likely to raise them next month removed any doubt that its tightening plan remains on track. Growing optimism about the US and global economy, along with President Trump’s economic plans which are regarded as inflationary, all weigh against bond prices.

For investors, the question of the correct level of bond exposure has become vexed. A rule of thumb used to go that you should hold a proportion of bonds that matches your age - 40-year-olds should hold 40% bonds, for example. As you aged the greater share of your money held in bonds meant the chance of damage from a sudden equity market fall was reduced.

You hear very few mentions of this rule nowadays. Emergency low interest rates and then bond-buying within quantitative easing programs pushed bond prices to such elevated levels that many believed buying them could only result in future losses. In the recent period, higher prices of bonds have coincided with rising stock markets meaning the two assets have become more correlated, further eroding the attraction of bonds as diversifers.

Demand has shifted instead to any alternative assets that pay income or have some diversifying effect on equities, including commercial property and infrastructure investments.

Some investors have been happy to load up on exposure to equities in defensive sectors with records of paying steady dividends - the “bond proxies”- or to make use of funds that includes derivatives and other more complex arrangements to provide a “cash-plus” return that can replace bonds in a portfolio.

So is there still a case for bonds as diversifiers? When you look at the potential downside for bonds from here, given stock markets are also near record highs, many will conclude not. There is, however, a danger that investors confuse correlated returns with correlated risks.

If a profound stock market correction arrives bonds could still provide valuable shelter because bond holders have a level of assurance about their income and capital in times of stress that equity investors simply don’t.

A significant correction in stock markets is unlikely to arrive unless expectations for the global economy also get significantly worse, which in turn will push central banks to loosen policy once again. Clearly, there is less capacity to do that than before the crisis but Janet Yellen, who leaves the Fed this month, can be credited with leaving her successor at least some room to loosen if another crisis does arrive.

Given the nerves surround stock markets right now, and despite the chance of further price falls, bonds shouldn’t be dismissed completely.


Important information

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