Bonds are back in style - and with good reason

This article was originally published in The Telegraph. 

WHEN we turn our attention to financial markets, the chances are we’re thinking about stocks not bonds. That’s strange when you consider that the global bond market is valued at about $300trn, more than twice the value of all the shares in the world. Imagine a news bulletin closing with the fixed income equivalent of the FTSE 100. Or try and name it, for that matter. Bonds don’t get the attention they should. 

Shares are easy to understand; we’re often familiar with the companies that issue them; and the link between commercial success and a rising share price is intuitive. Bonds are different; somehow faceless and dull even if they determine some important things, like the cost of a mortgage; even more confusing, they seem to go up in value when the economy’s struggling. No wonder investors tend to ignore this huge and influential market. 

All of a sudden, though, bonds are back on investors’ radars. Rising interest rates have boosted the income they offer. Meanwhile gung-ho central banks seem hell bent on driving the economy into recession, leaving our equity-heavy portfolios looking vulnerable. For years, bonds have been shares’ unfashionable country cousins. Now they are all the rage. It seems like a good moment to at least know the basics. Here’s what you need to know. 

The first thing to understand about bonds is the somewhat counter-intuitive point that their price goes down when the income they pay, measured by their yield, goes up - and vice versa. In an ideal world, the bonds in your portfolio would pay you a high and reliable income while also going up in value. So, it’s frustrating that one seems to come at the expense of the other. 

But hiding within that apparent confusion is an investment opportunity. If you time it right, you can lock in an attractive yield when interest rates are high and then benefit from a capital gain when the cost of borrowing subsequently falls and bond prices move in the opposite direction. This potential double whammy is one of the reasons why investors are excited about bonds today. 

Alternatively, if you buy a bond that was issued when interest rates were lower than they are today, you will pay less than the amount that you will be repaid at maturity. You are basically swapping the income you’re missing out on for a capital gain. Take this example: when interest rates were close to zero, the UK government issued a bond paying what now looks to be a paltry yield of just 0.25%, maturing in January 2025. If you were to buy this bond, it would cost you a little over £92 today to secure a more or less guaranteed £100 return in 18 months’ time. Even better, that high single digit return over a year and a half comes free of capital gains tax. 

There are two main factors that determine the price and yield of a bond. The first is how likely investors think it is that they will get their money back. This is known as credit risk. When a bond is issued by the government of a country that cares about its reputation and prints its own currency, there is almost no chance that it will fail to pay what it owes. Companies on the other hand can and do go bust at times. Investors will demand a higher income to compensate them for this risk. The gap between the income a government bond pays and that from a riskier issuer is known as the yield spread. When times are tough (during a financial crisis, for example) that spread can get very wide indeed. 

The second driver of price and yield is what an investor can earn from an alternative investment, such as putting their cash on deposit. If a central bank raises interest rates in a bid to get on top of inflation, then the income that can be earned from risk-free investments like cash deposits will also go up. And that can make the fixed income offered by a bond look suddenly less attractive. To ensure that a bond’s yield remains competitive in this situation, its price will tend to fall. This is known as interest rate risk. Remember price and yield move in the opposite direction. 

The next thing to know about bonds is that they don’t all respond in the same way to these changes in interest rates. The time remaining until a bond matures and repays investors their original investment is the main determinant of its sensitivity to changing rates, known in the jargon as its ‘duration’. There’s more to it than just the time to maturity, but all you really need to know is that the longer a bond is from repayment (and the lower its initial yield) the more reactive it will be to changes in interest rates. 

Look again at that short-dated UK government bond with only 18 months left on the clock. If you buy it and hold on to maturity you won’t care what happens to interest rates over the next year and a half. The return is pre-determined. If on the other hand you buy a bond that’s 30 years away from being repaid, and you think you might want to sell it before it matures, you will care a great deal. The problems experienced by pension funds last autumn when interest rates spiked higher were a consequence of them matching their long-term liabilities with long-dated, highly-interest-rate-sensitive bonds. Duration matters. 

Bonds have been described as dull by design, and investing in fixed income is certainly more complicated than thinking, for example, I like my iPhone so I’ll buy Apple shares. But the basic principles are relatively simple, especially if you stick to the bonds issued by governments whose word, quite literally, is their bond.  

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. 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.