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.

BONDS are at the lower end of the risk and reward spectrum. And while they might not be as ‘exciting’ as higher-risk equities - which includes both individual shares and equity funds - they have an important role to play in a well-diversified portfolio. So, if you’re asking yourself if now is a good time to buy bonds, here’s what you need to know to make an informed decision.

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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. 

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.    

Bond fund 

Edited expert view - see fund description for more information 

Colchester Global Bond Fund GBP Unhedged Accumulation Class I Shares 

This fund mostly lends to developed market governments within the US, Europe, UK, Japan and Australasia, but will also lend smaller amounts to governments in emerging markets. These investments tend to be low risk (since governments are the most reliable creditors) so income is likely to be quite low (although not guaranteed as losses are possible if interest rates go up). This fund is a potential helpful insurance policy against a global crisis or global recession - as it only invests in low-yielding and low-risk investments - so could be a defensive component in a wider portfolio. 

iShares Overseas Government Bond Index Fund UK 

 

This is an index-tracking fund that lends money to governments around the world. These tend to be low risk loans and attract commensurately low interest payments. The fund manager is a seasoned investor in passive funds and the fund’s costs are low. For investors seeking an exposure to global bonds, who have a long-term horizon and are cost-conscious, this fund represents a sensible choice on the lower risk side of a portfolio. The fund is likely to do well in an environment of falling interest rates. 

Legal & General Emerging Markets Government Bond Local Currency Index Fund 

This fund is an index tracking fund that lends money to governments within emerging markets - such as Thailand, Malaysia, Indonesia, China, Mexico, Brazil and South Africa. Governments will borrow in both local currency and US dollars, but this fund only lends money in local currency. L&G is a seasoned index tracker, and the fund is reasonably priced. This fund is a useful addition to an income portfolio, but the size of any allocation should reflect its riskier nature (because the fund operates in regions that are perceived to be riskier, the interest it receives on its loans is usually healthy and higher than if it had lent money to developed market governments). As such investors should take a long-term view (ten years plus).  

M&G Global Macro Bond 

This fund is flexible and can invest across multiple regions, lending to a range of government borrowers across the risk spectrum. This level of flexibility means that investment experience is vital. The fund manager is one of the most senior bond investors at M&G. The fund is flexible and should perform differently from more traditional bond funds. It could appeal to investors who are nervous about the outlook for bond markets but are still looking for some fixed income exposure. 

Royal London Short Duration Global Index Linked 

This fund lends money to governments around the world, with the interest paid on the bonds linked to inflation. The loans are made over short periods (under five years usually) and this also helps reduce the fund’s risk. If central banks raise interest rates in response to rising inflation, most bond funds will lose value and an inflation-linked fund can be helpful in this environment. The fund is low risk, pays out an income and is partially protected from increases in inflation. 

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.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates.  Investments in emerging markets can be more volatile than other more developed markets. Select 50 is not a personal recommendation to buy or sell a fund. 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. 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 one of Fidelity’s advisers or an authorised financial adviser of your choice. 

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