19 October 2022

Bonds – what’s happened and what does the future hold?

Experienced investors tend to take stock market crashes in their stride as we see them every few years and we know the drill, just stay in your seat and wait for the recovery to come, which it always has to date.

It’s little wonder therefore that investors have been pretty sanguine about the relatively modest negative returns from major stock markets this year. They are nothing compared to recent crashes.

Part of this lack of concern can be explained by the following analogy. If you have mild toothache and then someone drops a brick on your foot, all thoughts about the minor discomfort in your mouth are set aside to allow your mind to focus on the much more acute pain elsewhere.

The current stock market correction is but a mild toothache compared to what’s happening in the bond markets, which is most definitely a greater threat to wellbeing.

Bonds come in many shapes and sizes, but put simply, they are a way for governments and companies to raise capital from investors in return for an agreed interest rate over a set term. The highest rated bond issuers can offer a lower return than those with poorer credit ratings due to the perceived lower risk of not getting your money back. As interest rates rise, it becomes more difficult for poorer quality bond issuers to maintain their interest repayments and there may even be a risk of default when the bond reaches maturity.

Generally, longer term bonds have to offer higher rates than shorter term bonds to tempt investors to lend their money for longer.

So why have Bonds performed so poorly in the last year?

There are two things bond markets struggle with, rising interest rates and high inflation. Yes, that’s right, we’ve got both right now. In fact, we have the former because of the latter. Central banks have few weapons in their armoury to try to control inflation. Raising interest rates is their ‘go to’ tool to combat it.

The mechanics work like this; a rise in the market interest rate will make the fixed rate of interest offered on a bond less attractive than it was before the rise. To compensate for this, so the bond continues to be attractive to new buyers, the price drops, meaning that the buyer is buying the same fixed income stream for a lower initial investment.

Most investors will gain exposure to bond markets via a fund rather than by buying individual bonds. Doing so increases the diversification of a portfolio by providing access to hundreds or even thousands of bonds from across the world, denominated in multiple currencies. The extent to which the value of a bond fund will fall whilst interest rates are rising is determined by something known as its ‘duration’. It’s a measure of ‘interest rate risk’ and is calculated by taking account all of the interest payments still to be received until maturity on each bond. The rule of thumb being that for every 1% increase in interest rates, the bond fund’s price will fall by a percentage equivalent to its ‘duration’.

So, does this mean that you should sell all of your bond investments now? Certainly not, as you’ll be selling them for a knock-down price. It’s also worth remembering that as each interest payment comes into the fund, and as each bond matures, the proceeds will be reinvested into new bonds with much more attractive interest payments, increasing the expected return from the fund and helping to recoup the capital losses. For investors with an investment horizon longer than the duration of a bond portfolio, a rise in rates will create short-term pain, but long-term gain.

In the meantime, it’s most certainly a case of battening down the hatches and resisting the overwhelming temptation to do something rather than nothing. This is the worst bond market, not in a generation, but ever, and selling assets in such a market is to be avoided where possible.

If you have questions about the bonds in your portfolio, please speak to your financial planner who will be happy to provide more detail.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

Tax and Estate Planning Services are not regulated by the Financial Conduct Authority.

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