Bond yields are soaring. But don’t ditch your stocks yet

We used to talk about Tina - there is no alternative - when it came to choosing between bonds and shares. When interest rates and bond yields were close to zero and the stock market cheap and offering an attractive income, preferring shares to bonds was hardly going out on a limb.

Things look different today. 30-year bond yields this week hit their highest level since 1998, delivering an income of nearly 6%, which is roughly twice what you can earn from the average FTSE 100 share. For that reason alone, you might think that now is the time to consider a switch out of equities and back into fixed income. I’m not wholly convinced, but I’m getting there.

The arithmetic attraction of government bonds is particularly striking in the UK today, where yields are not only significantly higher than in other developed markets, but they have risen much faster. Since the beginning of the conflict in the Gulf, the 30-year bond yield has risen about three times as much in absolute percentage-point terms as it has in Germany, faster even than in the former fiscal basket case of Italy.

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The so-called Fed model, which compares the yields on bonds and equities, shows an unusually large gap between even medium-duration 10-year bonds (yielding about 5%) and the UK’s equity benchmark, which yields just over 3%.

Bonds look even more interesting because of the increasing vulnerability of equity markets, which are riding high on hopes for a resolution in the Gulf and happily dismissing the possibility of a 1970s-style stagflation shock. Shares are hitting new records in the face of sluggish growth and persistent inflation, going full in on the persuasive but unproven AI narrative.

Faced with the chance that shares could correct sharply if AI disappoints, bonds offer investors a safe and reliable income and a less volatile ride. What’s not to like? Well, a few things.

The first and obvious reason to be cautious about the outlook for bonds is that bond yields could yet rise further. This is particularly the case for longer-dated bonds that mature many years hence and are therefore a hostage to interest rate and inflation uncertainty.

A bond, especially one issued by a developed world government that will think twice before reneging on its fiscal promises, is simply a more-or-less-guaranteed stream of fixed cash flows. The value of that bond today is the present value of the coupons it will pay over time and the capital it will hand back at maturity.

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These future payments are discounted using prevailing interest rates, and the further away the payments are the more sensitive they are to changes in those rates. The UK Treasury 1.625% bond, maturing in October 2054, is priced at £42.60 today. Five years ago, when rates were lower, the same bond was priced at £120. It is worth bearing that in mind when people blithely refer to bonds as being lower risk than shares.

The second reason to hesitate before making the leap back into bonds is that the negatives for shares today are not exactly positives for bonds either. The correlation between bonds and shares has risen in recent years because governments are no longer capping bond yields at artificially low levels. The stag- part of stagflation may argue for lower interest rates but the -flation element pushes the other way. Markets are once again pricing in a couple of interest rate hikes in the UK this year. And the longer an investor has to wait to get their money back, the more compensation they will demand for the risk that inflation will erode its real value.

A third hurdle for bond investors is political uncertainty. If today’s local government elections are as bad for the government as feared, two scenarios emerge which could make bond markets even twitchier. Neither a swing to the left by the Labour party nor the ascent of either Reform or the Greens suggests an outbreak of fiscal prudence. Bond investors are in the mood to shoot first and ask questions later.

The pros and cons for bonds and equities make this sound more binary than it is. Clearly, we are no longer in a low yield environment where there is no alternative to equities. And we are not yet at the point where bond yields are too high to be ignored. Rather, we are in a tricky no-man’s land where it makes sense to balance a portfolio between the two asset classes and to shift progressively further into bonds if and when yields push higher.

There are a few ways to reduce risk further. The first is to limit the interest rate sensitivity of the bond element of a portfolio by focusing on shorter maturity issues that are less influenced by changes in the cost of borrowing or by inflation concerns. You may have to accept a slightly lower income by lending for 5-10 years rather than 30 but you will gain flexibility. You won’t regret that trade-off while the risks still lean more to rising than falling interest rates and yields.

Secondly, you can eliminate capital risk by holding bonds to maturity. This can be particularly helpful if you are exposed to capital gains tax, because government bonds are exempt.

Thirdly, you can boost the income you receive from your bonds by accepting some default risk. Companies pay more to borrow than governments do because they are more likely to miss their obligations to lenders. In practice, with larger borrowers, you may be compensated for a largely theoretical risk.

The case for bonds is strengthening, if not yet as compelling as a 28-year high for yields might imply. So, welcome to a new Tina - there is now an alternative.

This article was originally published in The Telegraph.

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Important information: investors should note that the views expressed may no longer be current and may have already been acted upon. 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. Overseas investments will be affected by movements in currency exchange rates. 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.