If you want to brush up on your bond knowledge, here’s a quick refresher. Otherwise let’s dive right into the case for investing in bonds.
Why has investor confidence in bonds recently been knocked?
Many investors favour the tried-and-tested 60% equities and 40% bonds ratio in their portfolio. And that’s because these two asset classes usually (note the word usually) perform differently in the same economic conditions. This has historically been useful when markets are volatile.
However, 2022 was a particularly challenging year for both bonds and equities. It left many investors questioning the traditional 60/40 split and challenging how their portfolios are weighted.
How have bonds done in 2023?
Interest rates have remained higher-for-longer than anyone expected. And that’s largely because even though inflation is coming down, it’s not decreased as quickly as people had hoped. Nor has it reached the government’s 2% target.
According to my colleague, Ed Monk, in the Investment Outlook Q&A, “it’s meant that a lot of people who have lost out on bonds in the last couple of years, are sitting on those losses, waiting hopefully for a recovery and bounce back in the prices – and looking for things that are going to trigger that” But he goes on to explain that “It’s probably worth saying that what we saw immediately before this period, was incredibly high bond prices and incredibly low interest rates… getting back to that is far less certain. We might see a partial reversal – but getting back to those levels might never happen.”
Are bonds a good investment?
This was actually a question that came up in October’s Investment Outlook Q&A session. Here’s what Tom had to say, when asking himself if it’s a good time to buy bonds or a bond fund.
“I think it is quite a good time to invest in bonds. Because interest rates are now pushed to a level where you can lock in quite an attractive yield – or income – from your bonds, maybe 5% (which is about the same as you can get from cash). And if interest rates do start to come down, and bond yields follow them down, I think what we will see is the potential for a capital gain as well. Because bond yields and bond prices move in opposite directions. As interest rates come down, the price of bonds will go up… so you’re locking in a good income and you’ve got the potential for a capital gain.”
As for whether it’s a good time for corporate or government bonds (called gilts in the UK) Tom feels that the balance between risk and reward is firmly skewed towards investing in government bonds, which is the part of the fixed income universe that is most sensitive to movements in interest rates. The chance of rates falling from their current level is greater than the possibility that they will rise much further.
If you were wondering why he’s not favouring corporate bonds, that’s because these bonds are also influenced by the health of the economy and its impact on companies. As the economy slows, more of these may fall into difficulties and become unable to meet their obligations to lenders. This is likely to become a bigger problem as more companies are obliged to refinance their debts at much higher rates.
For this reason, investors who are reaching for the extra income that corporate bonds offer compared with government bonds should err on the side of caution and only invest in the highest quality companies’ debts. So-called high yield bonds might look attractive on the basis of the income they offer, but the risks of failure are commensurately higher.
The short video below from Tom highlights the role government bonds can play in your portfolio.
