The financial markets have experienced heightened volatility over the last year. Some equity volatility was to be expected given everything that is going on in the world. But typically, investors expect bond investments to be much more stable than equities and do not expect the price of bonds to fall in tandem with the equity markets. 2022 was a very uncommon year, and many bond investors have seen losses equal to or more than those felt by equity investors.
Even if you don’t hold bonds directly, you may have exposure to bonds within your portfolio through multi-asset funds. If so, you have probably seen the impact of volatility in the bond market. Additionally, occupational pension schemes, which heavily invest in gilts, have also been adversely affected.
So what is causing this turbulence in a historically stable market, and is there anything you need to do about it?
A short guide to bonds
A bond is effectively a loan to a company or government. Loans to the UK government are known as ‘gilts’.
Most bonds have a fixed maturity date and an interest rate known as a ‘coupon.’ The coupon is fixed as a percentage of the original investment and must be paid by the issuer until the maturity date.
Bonds can either be bought from the original issuer or traded on the second-hand market. The price of existing bonds goes up and down with supply and demand in the same way as equities. However, because bonds come with a coupon and the promise of a capital repayment at maturity, they have historically tended to be less volatile than equities.
Even when the price changes, the coupon remains constant, which can make bonds attractive to buy when they have dropped in price.
You can buy bonds either directly, through an investment manager, or hold them within an investment fund.
There are four main risks involved when investing in bonds:
- The risk that the price will fall and you will get back less than you invested.
- The risk that interest rates will rise, and existing bonds will offer a poor rate in comparison.
- The risk that inflation will rise and your investment will lose value in real terms.
- The risk that the issuer will fail and you will lose your investment.
Types of bonds
The risk and return spectrum of bonds can vary considerably depending on several key factors, including the credit rating of the issuer and the term until maturity.
Types of bond include:
- UK gilts, i.e. loans to the government.
- Index-linked gilts which aim to keep pace with inflation.
- UK corporate bonds issued by companies.
- Overseas government bonds.
- Overseas corporate bonds.
A bond issued by an established, profitable company is likely to be less volatile than a bond issued by a small company in an emerging economy. However, riskier bonds also tend to offer higher coupons to compensate for the extra risk taken by investors.
The term of the bond also contributes to the level of risk. The longer the term, the greater the chance that the economy will change or the issuer could default. Long-dated bonds tend to offer higher coupons, but this is not always the case and the rates for bonds will depend on the economic outlook.
Factors affecting bonds
When inflation is on the rise, demand for goods and services is typically increasing which means that prices can go up. Steady inflation is viewed as a good thing, as it means the economy is growing. But sometimes prices can rise too quickly which can put a strain on finances.
When inflation is high, central banks will typically tighten monetary policy. This usually means increasing interest rates, making it more attractive to save and invest, and less appealing to spend and borrow. Borrowing can also become much more difficult in times of heightened inflation.
Higher interest rates mean that newly issued bonds also need to increase their rates to remain competitive. Existing bonds may be sold off as investors seek higher rewards or less risk. This can cause the price of existing bonds to drop substantially. However, once prices reach a low point, the bond may once again become attractive to investors as the coupons look favourable compared to the low purchase price. Bond volatility tends to be self-limiting.
In the UK, gilts have been regarded in the past as a safe haven as the loans are backed by the UK government. But UK debt is a major source of concern at the moment and the value of Sterling is also experiencing drastic volatility. Gilts have been the hardest hit amidst recent turbulence in the bond market.
The Bank of England is the largest investor in UK debt and has recently purchased a further £19.3 billion in gilts. The aim was to stop the price of gilts falling further and to help restore confidence in the UK market.
Should you still hold bonds in your portfolio?
The purpose of holding bonds in a portfolio is to provide stability, diversify your portfolio and to offset some of the volatility created by equity holdings.
In the current market conditions, bonds are behaving much more like equities. This can be concerning, especially if you are approaching retirement and have transitioned your money into such lower risk assets.
However, it is an expectation that bonds will experience volatility at some points in time. Occasionally they may become highly correlated with equities. However, over the longer term, bonds do act as a strong diversifier in a portfolio but it could take several years to see the benefits.
The basic principles of investing do not change, despite what is happening in the markets. If you diversify your investments, invest for the long-term, and avoid knee-jerk reactions to market events, it is likely that you will see positive returns.
Please don’t hesitate to contact a member of the team to find out more about your investment options.