Bond investors have had a pretty painful start to 2021, and if the global vaccine roll-out prompts a sharp economic recovery, price falls clocked up this year could be just the beginning.

Some bond funds have lost 8% so far in the year to date, and while that might not sound so bad to hardened equity investors, bonds are prized for being a safe asset.

The reason bonds have sold off this year is partly due to fear of inflation, the arch-enemy of the fixed income stream that bonds provide. But there are also growing expectations of rising interest rates. Vaccines are thankfully proving successful in combating the virus, and prompting markets to bake in prospects for a pretty strong economic recovery.

That lessens the need for central banks to keep interest rates low, and brings forward the date at which quantitative easing (QE) might start to be unwound, and interest rates hiked back up. That’s bad for bond prices because the main thrust of QE has been central banks hoovering up government bonds like hot cakes.

Without that huge demand, bonds don’t look quite as shiny. Rising interest rates on cash would also make the fixed income stream available on bonds look less attractive, again, denting prices.

BONDS SEE BIG LOSSES

All of the major bond sectors used by UK investors are nursing losses so far in 2021, apart from high yield bonds, which tend to have a greater correlation with equities and risk appetite generally. 

The worst affected sectors by far are those with high exposure to long dated, government bonds, which are most sensitive to falls and rises in interest rates. UK corporate bonds tend to be shorter dated, and carry higher yields to reflect the greater risk that a company will default compared to the government, and that affords them more protection from rising interest rates.

Two months is a very short period over which to just performance, and bonds have actually done tremendously well for investors over the last 10 years. Bonds still offer diversification for a mixed portfolio, because prices could rally if the pandemic takes a turn for the worse, or economies fail to deliver the growth that re-opening promises.

But the quakes we are seeing in the gilt market today are at the very least a reminder of the price falls that bond investors might face when the QE music stops, and the low yields currently on offer don’t offer a great deal of compensation for that risk.

What is quantitative easing?

Quantitative easing (QE) is a monetary policy whereby a central bank purchases at scale government bonds or other financial assets in order to inject money into the economy to expand economic activity.

It’s therefore worth bond investors taking a time-out, revisiting why they have an allocation to bonds, and considering if their exposure reflects the risks and potential rewards as they stand today.

DIVERSIFICATION BENEFITS

Bonds still offer diversification from equities, and if risk appetite wanes, bond funds can be expected to do well when equities fall. This still holds true today, though with bond prices already so high, the upside is much more limited than the potential downside.

The benefit of holding both bonds and equities together is these assets minimise portfolio volatility, though ultimately this may come at the cost of longer term returns.

The Barclays Equity Gilt Study analysed market returns since 1899, and found that over 10 years, returns from UK equities beat returns from UK government bonds 77% of the time. Given how well bonds have performed until recently, investors should check how much of their portfolio they now account for, and make sure they remain happy with this allocation.

INCOME APPEAL

The income produced by a bond portfolio has fallen as prices have risen. Like many income seekers, bond investors find themselves between a rock and a hard place. Cash isn’t offering a viable alternative, and gold pays no income.

Equities and property do generate a decent yield, but these come with added volatility.

UK Equity Income investment trusts might be worth considering for those willing to take on the additional risk of the stock market. The investment trust structure means the fund manager can hold back dividends in good years to pay out in the bad.

As a result, an investment trust like City of London (CTY) has an unbroken record of 54 years of dividend growth.

Within the fixed interest universe, investors can choose strategic bonds funds or high yield bond funds, which will offer a better yield than government bonds, but again this sit further up the risk spectrum in terms of price volatility, though actually they are lower risk in terms of their sensitivity to interest rate rises.

PORTFOLIO PROTECTION

Some investors choose bonds because they have low volatility and are generally considered safe. However that doesn’t take into account the big price falls we could see in some parts of the bond market if serious expectations of interest rate rises start to take over.

The poor performance we have seen so far this year is testament to that. If you simply want to preserve capital and want minimal risk, then cash has to be a consideration instead of bonds. Neither yield very much, but if interest rates rise, unlike bond holdings, cash won’t fall in value.

‹ Previous2021-03-04Next ›