Why it might be a better year for bonds

In recent years investors have had a challenging period finding income in bond markets. Given that the price of a bond moves inversely to interest rates, it means that the low interest rate environment that has characterised the last decade saw bond prices reach an all-time high. 

This has had an impact on the level of yield that a bond offers an investor. The yield of a bond can be used as a measure of expected return which considers both capital growth and income. As the price of a bond increases, the relative value of the income or coupon falls, for example a bond that pays £5 per year on a £100 bond would offer a yield of 5%, however if the bond price increases to £110 then the yield would fall to 4.5%. This reached an extreme level in 2021 when over 15% of the bonds in the Bloomberg Global Aggregate index (a composite of Government and Sovereign bonds) offered investors a negative yield. In other words, investors (if they held the bonds to maturity) would lose money. 

This remarkable feature in bond markets experienced a sharp correction as Central Banks began to raise rates, with the Bank of England becoming one of the first Central Banks to raise rates in December 2021. This set the scene for a rapid repricing in bonds as interest rates were aggressively hiked, causing the price of bonds to have an equally aggressive fall.

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Cheaper debt may come at a cost

There is, however, a nuance that an investor needs to be aware of which perhaps would have been an afterthought over the last decade. The ability for companies to issue cheaper debt has seen defaults remain low as companies have refinanced their existing stocks of debt at very low rates, often pushing the maturities back as far as possible. This has created an ‘island of tranquillity’ between 2021, when firms refinance at rock bottom rates, and 2025 onwards when that stock of debt begins to mature and needs to be refinanced at far higher rates (assuming central banks keep rates high). Should interest rates remain elevated, investors may need to start thinking more carefully about the ability of firms to avoid bankruptcy by rolling debt over at near zero rates.

The cheaper cost of debt has allowed companies to issue more debt and has created business models that only add up when the cost of financing is low. This has created large pools of debt that when rolled over to higher interest rates may no longer be viable, or as a minimum will pose a higher risk of default. As such, investors should exercise diligence over which issuers they decide to lend to, even if the current yields on offer look particularly attractive in relation to near history.

Yields have become very attractive

With those disclaimers in mind, the yields on fixed income securities have become very attractive. Looking first at sovereign bonds, for a 10-year Gilt the average yield over the past ten years has been around 1.3%, while it is currently paying 3.8%. For corporate debts the picture is much the same, with investment grade UK corporate bonds yielding around 6-7% where just two years ago they were yielding around 2-3%. Sovereign issuers who issue in their own currency don’t have the aforementioned issues of default risk, meaning those higher yields don’t come with the same downside risk that some corporate bonds do, particularly those in the high yield space. Additionally, it is very uncommon for investment grade bonds to default, as the process leading up to default tends to be quite long and usually includes those bonds being downrated out of investment grade. This means those who invest in investment grade bond funds will not have exposure upon default.

Yields at these levels puts bonds in a far better standing than when we entered 2022. Investment grade corporate bonds tend to have a maturity of around seven years, giving them a duration roughly similar (duration describes the % change decrease in price of a bond given a 1% increase in interest rates, and vice versa), meaning interest rates can rise another full percentage point above current expectations and an investment grade corporate bond holder receiving the going yield of 6-7% would be protected from capital loss. Given how far through the interest rate hiking cycle we are, the balance of probabilities weighs towards future rate cuts, rather than interest rate hikes beyond current market expectations.

Should a recession materialise that requires central banks to cut interest rates (as has historically tended to be the case), fixed income investors can look forward to capital appreciation on top of the healthy coupon payments that are currently on offer. In this scenario, bonds would be able to play their traditional diversifying role as they would appreciate in price while equities get hit. On balance, this makes fixed income attractive at this time, as you are being ‘paid to wait’ at current yield offerings and have the potential for healthy capital appreciation in a downturn.

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Please note: The value of investments can fall as well as rise, you may not get back what you originally invested. This article is for information purposes only and is not intended as specific or individual advice and should not be taken as such.