Article

Are bonds a good investment right now?

Following a sharp sell-off last year bonds are looking more attractive investments with significantly higher yields. Is now a good time to buy bonds?

| 8 min read

In 1982, the 10-year US government bond yield peaked at almost 16%. What followed was one the longest and most significant bull runs in investment history: almost 40 years of falling bond yields, and thus rising prices. For the best part of four decades bonds provided investors with relative stability and diversification from equity markets, as well as a decent source of returns.

Supported by quantitative easing (QE) in the aftermath of the 2007/08 Global Financial Crisis, the nadir for yields and peak prices arrived in the second half of 2020 with the 10-year US Treasury yielding 0.6% and the 10-year gilt (UK government bond) barely in positive yield territory.

Then, everything changed. Inflation, initially labelled ‘transitory’ by central bankers, became embedded. Rising energy prices, labour shortages, the cost of maintaining and rebuilding supply chains in the aftermath of the pandemic, and a more politically fractious world exacerbated by Russia’s invasion of Ukraine all contributed to inflation being greater and more prolonged than widely supposed. Also playing a significant part was the vast quantity of money created through QE to stave off a severe economic contraction amid restrictive Covid policies.

Central Banks may have been slow to respond to the threat of inflation but they have since doubled down in the fight against it, increasing interest rates in a sharp trajectory. Progressively higher interest rates are the tried and tested medicine to tame spiralling prices, and bonds previously yielding close to zero were subsequently cruelly exposed as being completely mispriced. The higher inflation and interest rates go the more investors require in compensation from financial assets, so the yields on bonds must rise to provide the appropriate return, and prices must fall. The longest dated and lowest yielding debt, ironically considered the ‘safest’ from a credit perspective, were the most affected. As a result, 2022 was the worst year for long-dated gilts on record, going back to the late 1800s. Prices continued to fall into the start of this year too with the 10-year gilt yield peaking at around 4.7% in August.

What happens next for bonds?

Following this seismic sell-off in bonds, things have started to stabilise as inflation expectations have begun to bed down and investors are now able to harvest significantly higher yields, be it in government bonds or the debt of companies – or ‘corporate’ bonds. We are now left with a bond market priced more realistically for the risks of an ongoing higher inflation and interest rate environment, and an asset class that we think offers significant opportunities. Follow the link to explore other types of fixed income investments.

In particular, for those envisaging a scenario of rates being cut sooner and faster, perhaps in the event that central banks misjudge interest rate hikes and cause a hard landing for the global economy, bonds potentially offer the best asset class available. It’s tempting to park money in cash right now, but when an investor buys a bond, the coupon is locked in for the whole term. If the coupon is, say, 5%, they can be assured that’s what they will receive each year until the capital is paid back (known as ‘redemption’). With a savings account, the bank may change the rate at any time, which they will if interest rates fall.

Is now a good time to invest in bonds?

Things are not clear cut as they depend on inflation and economic data going forward, but the Federal Reserve, Bank of England and European Central Bank have all signalled interest rates are close to peaking. In fact, they may already have done so. The earlier this becomes more certain the better the prospects will be for bonds and those who want to invest in them. Yields should fall if and when inflation and interest rate expectations subside, and prices should rise. Importantly, this means bonds are regaining their diversification benefits versus shares. A deep recession would probably be bad news for equities, but it would likely mean the pace of interest cuts increases which would likely benefit bonds.

That’s why we believe there is now good value in parts of the bond universe. As well as government bonds, ‘investment-grade’ corporate bond yields look attractive. Higher-quality credit will likely hold up better during an economic downturn and looks cheap relative to historic pricing, especially when considering the strength of balance sheets. For a more cautious approach less sensitive to inflation and interest rates, short-dated, high quality corporate bonds could act as a good ballast to portfolios with decent potential to outperform cash.

The flipside of a deeper recession scenario is that defaults (companies being unable to service or repay debts) are likely to rise in the riskier high yield end of the market if we see a deep recession. High-yield credit looks a bit expensive, and perhaps doesn’t price in all the recessionary risk. However, total yields are high, and the area could be an alternative to parts of the equity universe that delivers similar returns to shares but with a bit less downside and lower volatility.

Bond funds: ideas for your portfolio

These fund ideas are provided for your information but are not a guide to how you should invest. Before investing in any fund please read the relevant Key Investor Information Document or Key Information Document, and Prospectus to ensure they meet with your objectives and risk appetite.

For well-rounded, ‘core’ global corporate bond exposure, Vanguard Global Credit Bond Fund is one option that seeks to provide a moderate and sustainable level of income by investing in a diversified portfolio of global corporate bonds. Its focus is predominantly on developed market investment grade bonds, but with some scope to buy high yield bonds, investment grade emerging market bonds and other asset classes.

The very wide portfolio of high-quality corporate credits should have limited default risk during a recession, and the yield of over 5% (variable, not guaranteed) could provide investors with a solid income return with the added potential kicker of some capital growth if interest rates peak and subside. Investors’ bond exposure is often dominated by UK corporate bond funds, but the UK is only around 5% of the global fixed income market.

The global approach taken by this fund provides a much greater opportunity set. The fund is actively managed and is sufficiently selective to add value but diversified enough to mitigate the stock specific risks that can significantly impair returns. Overseas currency exposure is hedged in order to remove the additional volatility associated with foreign exchange markets.

For a more dynamic approach to the asset class Janus Henderson Strategic Bond is also worth considering. The key attractions are the depth of resource and the experience of the managers and the flexibility of the fund to invest across the spectrum of bonds from governments to riskier areas such as high yield. It has endured had a tough time from being positioned in longer duration bonds compared to most of its peers, but it does stand to benefit in an era of interest rate cuts with a present bias to good quality corporates alongside sovereign bond exposure. Relative returns will typically be more reliant on the asset allocation decisions made by the managers.

For those looking to allocate to UK gilts and government bonds a passive approach tends to make sense to in order to minimise management costs. Lyxor Core UK Government Bond UCITS ETF is one good-value option for gilts, and with around 40% of the fund in issues with maturities in excess of 15 years it is highly sensitive to interest rate and inflation expectations. Meanwhile, For a global perspective with bias to US X trackers Global Government Bond UCITS ETF is one option, and it has a currency hedged share class available for those wishing to strip out the effects of foreign exchange movements on returns.

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    Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.