Why bond yields matter

Tom Stevenson
Tom Stevenson
Fidelity Personal Investing17 May 2018

Are you interested in bond yields? No, I thought not. For many investors, they are right up there with watching paint dry. Unfortunately, they matter and today they matter more than they have done for a while.

So bear with me and I’ll explain why. Painlessly, I hope.

First, though, let me describe what has happened this week in two important bond markets - in the US and Italy.

The yields on US and Italian government bonds have both risen sharply this week. In the case of the American government debt that is due to be repaid in ten years’ time, it has moved to more than 3.1%, the highest level in seven years. In Italy, the equivalent bond yield moved above 2% this week, rising by 0.17 percentage points in one day, a big move in this market.

In both cases, the rise in the yield reflects a fall in the price of the bonds. This is simple arithmetic. Because the yield represents the income as a proportion of the price, a fall in the price increases the yield and vice versa.

So, investors have become less keen on holding US and Italian bonds. Interestingly, they have done so for different reasons.

In the case of the US, the yield has risen because of a fear that inflation is returning to the US economy. This has been prompted by particularly strong retail sales figures which suggest that low unemployment, tax cuts and buoyant corporate profits are beginning to feed through into higher consumer confidence, which is supportive of higher prices in due course.

This is bad for two reasons. First, rising prices make it more likely that interest rates will rise. And rising interest rates make it more attractive to hold cash even than super-safe US government debt. In order to attract investors, the yield on the bonds needs to rise. The price needs to fall a bit, therefore.

Inflation is also bad for bond prices because it means the bonds will be worth less in years to come in real, inflation-adjusted terms. In order to compensate for that, investors demand a higher income today. Again, the price needs to fall a bit to create this extra income.

In Italy, the yield has risen for a different reason. Here investors are shunning Italian bonds because they are worried - not about inflation but about the credibility of the Italian state’s promises regarding its debts. Investors see a high-spending, populist government in prospect in a country which already has high debts and they wonder how it can end well. They even see a threat to the sustainability of the Eurozone from the policies of the two parties currently trying to put together a coalition and they are demanding a higher income to compensate them for the risk that they might not get their money back in full.

The US government bond market is the most important in the world. That’s because the price of many financial assets is heavily influenced by the price of (and income derived from) US Treasury bonds. The Italian bond market is important because it is one of the biggest in the world and sits at the heart of the Eurozone.

Now why do rising government bond yields matter? Obviously, they are of concern to investors holding these bonds in their portfolios. As we have seen rising yields imply falling prices.

But they also matter because of the role of government bonds at the foundation of the financial system. Investors demand a higher yield from riskier investments, like corporate bonds or equities, than they do from government bonds. This means that a rise in the yield on government bonds usually implies a rise in the yields on other assets too.

Dwindling appetite for government bonds can mean a dwindling appetite for all forms of risk.

So, this explains why there is so much interest from finance professionals in this apparently obscure corner of the market. What happens here can have a big impact on everyone’s wealth so it is worth watching closely.

It’s not all bad news, though. Markets have a tendency to be self-correcting. As bond yields rise they become increasingly attractive to investors. Yields can only rise so far before investors start buying the bonds again, the price rises and the yield falls back down.

This is particularly the case with a safe investment like US Treasuries. At the slightest whiff of danger, investors welcome the relatively safe haven provided by the promises made by the American government. Especially if it offers a relatively high yield.

Put it all together and you can see that there are reasons to be nervous about bonds today but also to enjoy the balance they can provide to a portfolio. Having a mix of equities and bonds can help protect your investments from uncertainty and the ups and downs of the economy.

The Select 50 list of our preferred funds includes a wide range of different bond funds - 10 out of the 50, in fact, including government bonds, corporate bonds and even some designed explicitly to protect investors from inflation.

If you do not fancy choosing bond funds yourself, you might consider the Select 50 Balanced Fund which is designed to hold a balance of equity and bond funds from the Select 50. Currently, it holds a balanced of around 60% in equities and 30% in bonds with the remainder in cash and alternative investments.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.