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.

This article was originally published in The Telegraph.

SLACK water. The brief moment when the tide is neither ebbing nor flowing and there’s an eery calm. That’s how the bond market feels at the moment. A change of direction is imminent but we’re not quite there yet. It feels like an opportunity.

Last year was a nightmare for bond investors, just as much as for their counterparts in the equity market. Whether you held government bonds, high quality corporate credit or riskier high yield paper, you would have taken a hit. US Treasuries fell 13% while Gilts were 25% down. High yield bonds did a bit better than safer investment grade issues, but the losses were still in double digits.

There’s no secret about why bonds fell last year. The arithmetic is simple. When interest rates go up and investors can earn a better return on cash, the yields on bonds need to rise to remain competitive. With a fixed coupon, the only way that can happen is if the price of a bond falls. This is why interest rates and bond prices move in opposite directions.

The good news is that what created headwinds for investors last year looks like providing a tailwind in 2023. Last year interest rates were hiked in response to soaring energy and food inflation and a red-hot labour market. We are still waiting for that tide to turn this year, and May has already seen further rate hikes in the US, Europe and here in the UK, but we are at or close to the peak.

This is particularly the case in the US where evidence is mounting that the Fed has done what it usually does during a monetary tightening cycle - it has squeezed until something broke. There are company specific factors at play in the still unresolved regional banking crisis in America, but the principal reason for the sector’s turmoil has been the pace and extent of rate hikes, the impact these have had on banks’ holdings of long dated bonds and the way in which rising money market fund yields have made switching out of deposits an easy decision for nervous savers.

At the same time, the US consumer who has single-handedly kept the show on the road is looking nervously over her shoulder. Last week’s University of Michigan consumer sentiment survey was a shocker, with a reading of 57.7 missing estimates of 63.0 by a country mile.

The Federal Reserve has been waiting for the data to give it reason to pause. It’s still a mixed bag, with low unemployment, rising wages and core inflation still persistently above target, but the time to pivot is upon us. Interest rates are now above the underlying inflation rate, which is typically where they stop rising. The futures markets are looking for a first cut in the autumn and maybe three by Christmas.

Meanwhile in the corporate world, the number of profits warnings is rising. The first quarter results season was pretty good, but the cracks are beginning to show in terms of margins. A mild recession remains the base case at some point in the next 12 months.

The tide is probably further from the turn here than it is on the other side of the pond. Inflation remains stubbornly in double digits in the UK, although I would expect it to fall pretty rapidly from here. Even in Europe, where a mild winter helped fend off an expected economic slump and prices are also rising too quickly, the ECB is sounding progressively less hawkish.

What happened to the bond market last year created the conditions for a meaningfully better year in 2023. First, it pushed yields to levels at which they are a viable source of income for the first time in years. A two-year Treasury bond yields 4% today, a 10-year UK Gilt not much less. Buying at today’s prices locks in that income with no realistic danger that you won’t get your money back at maturity.

If you are prepared to move further up the risk scale, you can realistically expect to earn more than 5% on a bond issued by a blue-chip American or European company. If you can accept the greater risk of default on a high yield bond from a second-tier issuer, then an 8% income could be your reward.

The second reason to buy a bond is because you expect to be able to sell it for more than you paid. The odds of being able to do so are shortening as we move closer to the turning of the interest rate tide. If this is your goal, longer dated government bonds are where you should be looking - minimal default risk and the highest sensitivity to changes in the cost of borrowing.

The third argument for buying bonds now is that they look relatively appealing compared to shares. The US stock market is priced at 18 times expected earnings, which is not cheap in the face of an impending recession and associated earnings slowdown. Bonds and shares are unlikely to fall in tandem as they did in 2022, so there’s a diversification benefit too.

Arguably the moment when the tide is just about to turn at the peak of the interest rate cycle is the best time to favour bonds over shares. Equity markets often underperform in the months after a peak in the monetary cycle because investors start to focus less on the direction of travel for interest rates and more on the reason why they are falling. This is why it is also too early to be looking at riskier high yield bonds, for which rising default risk can outweigh the benefit of falling interest rates.

This is not a time to abandon the stock market in favour of bonds. But, as the tide turns this summer, I don’t think anyone will regret tilting their portfolio a bit more towards fixed income.

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.

Share this article

Latest articles

Is now the time to invest in the UK?

The case for investing in the UK

Graham Smith

Graham Smith

Investment writer

The 150-year-old investment trust that’s a best-seller

An internationally diversified portfolio aiming for growth

Nick Sudbury

Nick Sudbury

Investment writer

Retire early? Forget ‘FIRE’ and follow ‘CHILL’

Financial independence at all costs may not be worth it

Andrew Oxlade

Andrew Oxlade

Fidelity International