- Bond yields have gone back to the noughties
- Government bonds have been a disaster zone for investors in the last two years
- An update on pension lifestyling funds
- Is now a good time to invest in bonds?
- How to invest in bonds
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“It’s the best of times and the worst of times to be a bond investor. Yields are now high enough to feel like a gold rush to fresh investors who have been starved of income since the financial crisis. But at the same time rising yields have created heavy losses for existing bond owners. The 10 year US Treasury Bond yield recently rose above 5% for the first time since 2007, up from 0.6% in 2020. Likewise the UK 10 year gilt stands at 4.5%, its highest level since the financial crisis. Bond yields have gone back to the noughties, and it’s been a painful transition for bond holders.
Source: St. Louis Federal Reserve, Refinitiv data
“Clearly inflation and rising interest rates are the major culprits in the sell-off, but the beginning of the fall in government bond prices actually predates the beginning of the rate hiking cycle. As the table below shows, across developed markets the rot really set in around three years ago, when bond prices moved off their pandemic highs, as vaccines emerged and economic recovery kicked in. The inflationary crisis and tighter monetary policy still account for the lion’s share of the downdraft, but the market was already priced for a fall of historic proportions due to the extreme level bonds had reached in the decade after the financial crisis, which was exacerbated by the pandemic. The recent bond collapse has been brutal, basically all but wiping out the return from developed market government bonds over the last ten years.
|TOTAL RETURN %|
|1 yr||2 yr||3 yr||10 yr|
|FTSE Act UK Conventional Gilts All Stocks||-5.8||-27.0||-30.2||1.1|
|Markit iBoxx EUR Sovereigns||-2.0||-18.1||-20.8||5.9|
|Markit iBoxx USD Treasuries||-0.8||-15.3||-17.5||5.1|
Source: Morningstar total return in local currency to 31 October 2023
“Many UK investors hold UK bond funds, and while the fixed income markets of the US, Europe and UK are heavily related, they do wax and wane at different cadences. The UK conventional gilt market has been hit particularly hard by the recent sell-off due to the longer maturity profile of its debt basket, which makes UK gilt prices more sensitive to rising interest rates. Having longer dated debt is better from the Exchequer’s perspective though, as it means not having to refinance that debt quite so soon. But from the point of view of many investors, government bonds have been nothing short of a disaster zone in recent years, as the table below shows.
|TOTAL RETURN %|
|Sector||1 yr||2 yr||3 yr||10 yr|
|Annuity hedging funds||-12.9||-43.9||-46.3||-6.1|
|IA £ Corporate Bond||3.6||-15.2||-14.2||20.9|
|IA £ High Yield||6.8||-5.5||3.5||32.9|
|IA £ Strategic Bond||3.2||-11.1||-7.3||22.9|
|IA UK Gilts||-6.3||-27.4||-31.1||1.3|
|IA UK Index Linked Gilts||-12.1||-41.8||-39.2||4.5|
Source: Morningstar total return in GBP to 31 October 2023
“Investors in the typical UK gilt fund have seen their investment lose almost a third of its value in three years. Index-linked gilt investors have seen their funds fall by almost 40%. Those are quite some numbers to swallow for investors who no doubt invested in gilts partly because of their safe haven status. The good news is the vast majority of investors holding these funds will do so alongside equities, cash and alternatives, and so their overall portfolio is likely to have suffered less as a whole. The Sterling Corporate Bond and Strategic Bond sectors are also much more popular than the UK gilt sectors, and returns here have not been nearly as negative.
“Some sympathy must certainly be afforded to those in lifestyled pensions though, who are automatically shifted into bonds as they approach retirement as part of the default strategy within their pension plans. These annuity hedging funds have on average lost over 40% of their value in just two years, because they invest in longer dated bonds, to try and mirror annuity rate movements. Two years before retirement, a typical lifestyling strategy would normally be holding around half an investors’ pension pot in an annuity hedging fund. So close to retirement, these investors have very few levers to pull to reverse such damaging performance. Those who are buying an annuity with their pension pot might be more sanguine about the fall in their pension pot because annuity rates have risen so substantially, which offers some compensation. But since the Pension Freedoms were introduced in 2015, only around one in ten retiring pension savers have been buying annuities.”
Is now a good time to invest in bonds?
“Bonds of all shapes and sizes are back on the menu for investors. For over a decade following the global financial crisis, these investments offered little in the way of return and carried significant price risk. But the return of inflation and higher interest rates have changed all that. Today you can get a 4.5% annual yield on a UK government bond maturing in ten years’ time. That compares to under 0.2% in the depths of the pandemic in 2020. To spell out the gargantuan difference between these two yields, if you invested £10,000 in a bond yielding 0.2% per annum, and held it to maturity, you would get back £10,202 after 10 years. If instead the bond was yielding 4.5%, you would get back £15,530.
“The yields on bonds will therefore look pretty tempting after the income drought of the 2010s. We are also getting towards the peak of the interest rate cycle, if we aren’t there already, so further price damage from rate rises looks limited. The best time to invest in government bonds in the monetary cycle is when rate expectations are peaking, so yields are at their fattest and any drop in expectations will boost capital values. In the UK, the market is now not expecting any further rate hikes from the Bank of England, and actually expects the next interest rate move to be a cut, towards the back end of next year. If correct, that suggests there’s not much more yield to be squeezed out of the market, and expectations for future rates may start to fall, especially if we continue to see inflation drop away and the labour market slacken.
“Despite rejuvenated yields and peaking interest rates, the outlook for bonds is not without its risks. At a government bond level, there is a lot of supply around, as governments are still financing deficits while central banks are selling down their QE holdings. The market might not be able to digest all the bonds being thrown at it. We’ve also had a recent credit rating downgrade for the US government, and any further action on this front might unsettle markets. Elections in the US and UK next year also potentially threaten to cause disruption given the renewed focus on the sustainability of government finances. Meanwhile inflation is still with us and a rising oil price gives further cause for concern. Central banks may yet again be called into action to tame rising prices.
“Corporate bonds are priced off government bonds, and so some of the same concerns prevail. In addition investors need to be more aware of default risk, or perceived default risk, feeding into prices. This will be elevated if the global economy takes a turn for the worse and this feeds into company revenues, which ultimately service corporate debt. Higher interest rates in themselves also present a problem for companies, and those refinancing their debts at today’s market rates might find themselves on the end of a significant and unpleasant jump in their interest payments, not unlike mortgage borrowers rolling off favourable older fixed term deals onto the much costly contracts available in the market right now. One third of the profit warnings from UK companies issued over the summer cited tighter credit conditions, the highest level since 2008, according to the accountancy firm EY. That may well be a taste of things to come as older corporate debt is refinanced while consumers are still battening down the hatches, putting pressure on company earnings.”
Who should invest in bonds?
“The bond market has definitely woken up and is offering more compelling value than it has for a long time. There are essentially two key reasons for investing in bonds: income and diversification. Bonds (usually) provide investors with a decent level of interest, which can be attractive for income-seekers, particularly in retirement. At the same time a bond allocation held alongside equities can dampen the volatility of the portfolio as a whole, because bond prices tend to fluctuate less, and often move in the opposite direction to stock markets.
“The lower volatility of bonds also tends to make them favoured for lower risk investors, but as recent performance shows, bonds can experience significant downdrafts too. However the extreme price falls we have seen in government bonds largely reflect the extremely high prices they traded at before the inflationary crisis. Pricing in the bond market is now much more reasonable, and the valuation risk substantially lower. Cautious investors need to weigh up the pros and cons of bonds versus cash and money market funds, while also considering the overall bond/equity split of their portfolio.
“Investors do need to consider a bond allocation in the context of other assets though, chiefly equities and cash. Shares are still likely to deliver better returns than bonds over the long term. Data from Barclays stretching back to 1899 shows that over a ten year period, shares fare better than gilts over three quarters of the time. Investors who have a long time horizon might decide to forego bonds entirely, for instance younger pension investors. This is despite the fact that most workplace pension default funds will have a sizeable allocation to bonds, because of their cautious one-size fits all nature, so pension savers should always consider whether a more adventurous fund might be able to deliver a bigger retirement fund.”
How to invest in bonds
“Investors can buy UK government and corporate bonds directly, and in some cases there may be tax advantages to doing so. However most investors will probably find themselves gaining exposure to the bond market through a fund, and there are a number of options on this front. Investors can choose funds which invest in government bonds, in high quality corporate bonds, or in lower quality high yield bonds. Government bond funds will tend to be related to a specific region, such as the UK, Europe or US, while corporate bond funds will be related to the currency in which the debt is issued, such as sterling or the dollar. This doesn’t necessarily match up with the country where a company’s stock is listed, for instance a company listed on the London Stock Exchange might borrow money in sterling, dollars or euros. Some funds are flexible in their approach and invest across government, corporate and high yield bonds and across geographies and currencies. To add to the fun, some funds hedge most of their overseas exposure back to sterling to mitigate currency risk, others don’t.
“Bond funds also come in both active and passive flavours, for those who want to try to beat the market, or just follow it. Funds with an ESG focus can be found amongst both active and passive strategies. Active bond funds tend to be a bit cheaper than active equity funds. For instance, the average active UK corporate bond fund charges 0.49% per annum compared to 0.84% for the average UK equity fund. Tracker funds in each sector are more evenly priced, with the average UK corporate bond tracker fund costing 0.13% and the average UK equity tracker costing 0.15% (Sources for charges: AJ Bell and Morningstar).
“On the passive side of things both unit trusts and ETFs are available. For long-term investors there is little difference between the two structures, though ETFs trade throughout the day, allowing more nimble entry and exit points. Alongside plain vanilla bond ETFs there are more specialist vehicles aimed at the institutional market which focus on specific bond maturities, a level of complexity and intricacy which is unlikely to appeal to retail investors.
“Another option for those who want bond exposure is to get it through multi-asset funds. As the name suggests, these funds invest across a variety of asset classes including shares, bonds, cash, commodities, property and currencies, and cater to a range of investor risk profiles. The fund manager decides the allocation to bonds and other assets, so this is a hands-off approach which is often used by DIY and advised investors looking for an off the shelf one-stop solution.”
“Bond interest can form part of your Personal Savings Allowance, if it isn’t already being used by savings account interest, which is much more likely nowadays given healthier bank rates and frozen income tax bands. Otherwise bond interest is taxable as income, so by holding bonds or bond funds in a SIPP or ISA you can save 20%, 40% or 45% tax on your income payments. Bond funds are also potentially subject to capital gains tax if held outside of a tax shelter like a SIPP or ISA. However individual gilts and qualifying UK corporate bonds aren’t subject to capital gains tax if held by investors directly, i.e. not through a fund.
“For multi-asset funds, income payments are treated as interest if the fund holds over 60% of its value in fixed income securities (bonds and cash), otherwise the distributions are treated as dividends. If held outside a SIPP or ISA this would bring the £1,000 dividend allowance into play (falling to £500 next tax year). Annual dividends above this amount are taxable at rates of 8.75%, 33.75% or 39.35% depending on whether you’re a basic, higher or additional rate taxpayer.”