Are bonds a good investment?

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.

If you want to brush up on your bond knowledge, here’s a quick refresher. Otherwise let’s dive right into the case for investing in bonds. 

• What are bonds?
• What affects bond prices?
  

Why has investor confidence in bonds recently been knocked? 

Many investors favour the tried-and-tested 60% equities and 40% bonds ratio in their portfolio. And that’s because these two asset classes usually (note the word usually) perform differently in the same economic conditions. This has historically been useful when markets are volatile.  

However, 2022 was a particularly challenging year for both bonds and equities. It left many investors questioning the traditional 60/40 split and challenging how their portfolios are weighted.   

How have bonds done in 2023? 

Interest rates have remained higher-for-longer than anyone expected. And that’s largely because even though inflation is coming down, it’s not decreased as quickly as people had hoped. Nor has it reached the government’s 2% target.  

According to my colleague, Ed Monk, in the Investment Outlook Q&A, “it’s meant that a lot of people who have lost out on bonds in the last couple of years, are sitting on those losses, waiting hopefully for a recovery and bounce back in the prices - and looking for things that are going to trigger that” But he goes on to explain that “It’s probably worth saying that what we saw immediately before this period, was incredibly high bond prices and incredibly low interest rates… getting back to that is far less certain. We might see a partial reversal - but getting back to those levels might never happen.”  

Are bonds a good investment? 

This was actually a question that came up in October’s Investment Outlook Q&A session. Here’s what Tom had to say, when asking himself if it’s a good time to buy bonds or a bond fund. 

“I think it is quite a good time to invest in bonds. Because interest rates are now pushed to a level where you can lock in quite an attractive yield - or income - from your bonds, maybe 5% (which is about the same as you can get from cash). And if interest rates do start to come down, and bond yields follow them down, I think what we will see is the potential for a capital gain as well. Because bond yields and bond prices move in opposite directions. As interest rates come down, the price of bonds will go up… so you’re locking in a good income and you’ve got the potential for a capital gain.” 

As for whether it’s a good time for corporate or government bonds (called gilts in the UK) Tom feels that the balance between risk and reward is firmly skewed towards investing in government bonds, which is the part of the fixed income universe that is most sensitive to movements in interest rates. The chance of rates falling from their current level is greater than the possibility that they will rise much further. 

If you were wondering why he’s not favouring corporate bonds, that’s because these bonds are also influenced by the health of the economy and its impact on companies. As the economy slows, more of these may fall into difficulties and become unable to meet their obligations to lenders. This is likely to become a bigger problem as more companies are obliged to refinance their debts at much higher rates.  

For this reason, investors who are reaching for the extra income that corporate bonds offer compared with government bonds should err on the side of caution and only invest in the highest quality companies’ debts. So-called high yield bonds might look attractive on the basis of the income they offer, but the risks of failure are commensurately higher.  

The short video below from Tom highlights the role government bonds can play in your portfolio.

Government bonds listed on the Select 50  

If you’re looking to diversify your portfolio by holding a proportion of government bonds, I’ve listed those bond funds which sit in Select 50 - our favourite funds selected by experts - below. We currently have five on the list. Please take your time to read through the fund factsheets before investing. You’ll find links to each fund in the table. And investment writer Nick Sudbury takes a closer look at the iShares Overseas Government Bond Index Fund here.    

What are bonds?

Bonds are a debt-based investment. Think of them as IOUs. When you buy a bond, you’re effectively loaning money to either a government (these are also known as gilts in the UK or Treasuries in America) or a company (corporate bonds) for a fixed time period. At the end of this fixed period, the bond will mature and repay the initial capital. In addition, along the way the borrower will pay an annual fixed rate of interest to you the lender - also known as the coupon.  

Some bonds are short-dated and mature within five years, typically one to three years. As these carry less inflation and default risk, they usually receive lower interest (or yield/income). And some are long-dated bonds - which tend to receive higher interest.  

It’s worth noting that sometimes the interest on short-dated bonds can be higher than on longer-dated bonds. This tends to happen when central banks are increasing interest rates aggressively and can be an indication of an economic slowdown or recession ahead. This situation is known as an ‘inverted yield curve’. 

What affects bond prices? 

A bond’s price is primarily influenced by three things.  

• Supply and demand - when supply is high, price is low and vice versa. 
• Term to maturity - As the maturity date gets closer, the bond price will naturally move towards the value that the investor paid for it (in other words the borrower pays the investor’s IOU back - which in the UK is always £100). This is known as the par value. Over the course of a bond’s term to maturity, its price will be higher or lower than the par value of £100 depending on whether its yield to maturity (the total return anticipated on a bond if the bond is held until it matures) is higher or lower than the prevailing interest rate. 
• Credit quality - corporate bonds tend to offer higher rates of interest, also known as yields, as they’re riskier than government bonds (as governments don’t often collapse). Investors demand a higher rate of interest to compensate them for the greater risk. 

But there are also all sorts of other secondary influences which affect bond prices, such as: 

• Interest rates - Imagine bonds and interest rates were sat on either end of a seesaw. When interest rates go up, bond prices go down. And when interest rates go down, bond prices go up. They generally move in opposite directions. Short-dated bonds are less exposed to interest rate risk.  
• Inflation - One of the biggest threats that bonds face is inflation. As prices rise, they erode the value of the fixed income payments you receive on a bond. If you’re earning 3% interest on a bond but inflation is 6.7% (as the headline figure for September revealed just this week, not budging from August levels), you’re actually losing money in ‘real’, inflation-adjusted terms. Long-dated bonds are more exposed to inflation. 
• Other factors such as taxes or wages - these all indirectly affect bond prices as they influence investors’ decision-making process. This has a knock-on effect on the supply and demand, which in turn affects bonds prices.