Should investors keep on buying bonds?

“Early, not wrong” seems like a fitting mantra for a bruised bond investor currently seeking reassurance. It’s nearly two years since yields on benchmark US government bonds moved above the 2 per cent threshold, marking the start of a trend that ultimately began to attract buyers in late 2022. Sales of bond funds then picked up notably for much of the past year.

But the 'bargains' have got cheaper over much of that same period, with 10-year US Treasury yields, which move inversely to prices, moving well above the 4 per cent mark this year for the first time since 2008. Sometimes viewed as a 'risk-free' asset, government bonds have therefore been an easy way to lose money for much of this year, for those skittish enough to sell out and realise their losses at least. It has been a similar story for UK gilts, even if the price action has been less severe than in 2022.

However, at the risk of repeating the message from last year, bonds still look particularly cheap – and conditions may now be turning in their favour, if the price recovery in late 2023 is to be believed. As ever, selecting the right instruments will be key, and so too may be having a stomach for volatility.

The case for optimism

In theory, bonds should be on a steady footing. Yields still look attractive and valuations low, the former recently amounting to 4.3 per cent on the 10-year US Treasury and slightly less on equivalent UK gilts. That means investors are guaranteed a respectable enough return if they can simply hold such instruments to maturity – assuming the likes of the US government do not default on their debt. Valuations also point to scope for a recovery in prices.

The price falls seen for most of 2023 reflect the effect of interest rate rises, inflation's persistence and the risk that we are now in an era of higher rates altogether. But that means plenty of pain has already been priced in, hence the recent recovery. Government bonds rallied strongly in November 2023 in the hope that rates in the US are on course to plateau or even fall in the not too distant future.

The US is deemed by some to be slightly ahead of other developed nations in its monetary policy cycle. But peers are not far behind – in the UK, for example, the Bank of England has held interest rates twice in a row at the time of writing, ending an almost two-year run of consecutive increases. That bodes well for bonds. Even if the sharp rate hikes of the past two years do help send the economy into a downturn, it’s likely investors will once again seek government bonds as a safe haven – pushing prices up and yields down.

Bond buyers who move up the risk spectrum will find much higher yields, with some corporate bond funds yielding around 6 per cent and riskier forms of debt – from 'junk' bonds to private credit – approaching or even exceeding double-digit yields.

But the potential for volatility is certainly worth keeping in mind: bond investors have endured plenty of heavy sell-offs in the past year or so, and any expectation that rates could stay higher for longer than anticipated might prompt further price weakness. Fixed-income investors also have plenty of very different ways to play the asset class, with notable pros and cons to each.

The long and the short of it

AJ Bell's head of investment analysis, Laith Khalaf, recently summed up the main thinking on government bonds, noting: “The best time to invest in sovereign 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.” But as he acknowledges, risks do remain. Increased supply of government debt could weigh on prices, while unwelcome surprises (such as ratings agency Fitch downgrading US government bonds earlier this year) could hurt sentiment on the asset class. From upcoming US and UK elections to lingering inflation, other factors could also mean trouble ahead.

Investors also have plenty of choices when it comes to their government bond exposure. One big call when looking at both government and investment-grade corporate bonds in particular relates to the level of duration, or sensitivity to interest rate changes, they take on. Short-duration bonds have proved popular as a way of limiting exposure to further rate rises, while still offering much improved yields.

Chris Iggo, chair of the Axa IM Investment Management Institute, recently argued that because central bankers are suggesting interest rates will be on hold for a prolonged period rather than falling in the near term, short-duration bonds should continue to offer good yields and still rally once rate cuts eventually emerge. However, he notes that the best entry point may already be behind us, with the yield on the one-to-three-year segment of the US Corporate Bond index having fallen by 50 basis points from its October high.

By contrast, he says of the case for taking on long-duration exposure in the context of economic risks: "Once the market gets wind of the central bank pivot, the second phase of the long-bond rally can get under way. The first phase was the retreat from the symbolic 5 per cent yield on the benchmark US 10-year Treasury note from 23 October. The second phase will recognise that rates are on a path towards a new equilibrium which is higher than what prevailed before the pandemic but is lower than the peak we will have lived with for the best part of a year.”

Long-duration instruments will offer chunkier yields but are subject to much bigger moves in price when interest rate expectations shift, meaning they are typically only a choice for high-risk investors – unless you are prepared to hold them to maturity.

Not all debt must be long-dated in order to offer higher yields. High-yield corporate bonds, issued by companies with lower credit ratings, have proved more resilient in the face of rate rises. But they could face a much greater risk of default in future thanks to these companies' higher refinancing costs and the possibility of more challenging economic conditions.

Decisions, decisions

Investors have multiple forms of access to the bond market depending on their views and preferences. Those wishing to outsource their decisions to a team with a flexible remit might use a strategic bond fund, which can buy different types of bonds from across the asset class. The biggest funds in this area have used their flexibility to take some notable calls of late. Janus Henderson Strategic Bond (GB0007502080), for example, has taken a large exposure to government bonds as well as high levels of duration. Government bonds recently accounted for roughly half the portfolio. Investors keen to take on riskier high-yield exposure might also be tempted to do this via a more flexible fund; in which case names such as Royal London Sterling Extra Yield Bond (IE0032571485) stand out.

Investors who simply want to buy government bonds can do this easily via passive funds, and our latest Top 50 ETFs list includes funds with a mixture of different durations in the portfolio, such as the Lyxor Core UK Government Bond ETF (GILS), as well as more targeted options such as the short-duration iShares $ Tips 0-5 ETF GBP Hedged ETF (TI5G). Long-duration funds also exist, including the iShares $ Treasury Bond 20+yr ETF (IBTL) and SPDR Bloomberg 15+Year Gilt ETF (GLTL). But as these funds roll over holdings themselves, the benefit of holding to maturity doesn't apply: investors must instead reconcile themselves to increased interest rate risk.

That said, there are funds that function more like direct bond investments. iShares launched its iBonds ETFs, the first fixed-maturity bond ETFs in Europe, earlier this year. They mature on a fixed date just like their underlying portfolio of bonds, at which point they pay out their net asset value (NAV) to shareholders. That allows investors to build so-called 'bond ladders', a strategy that involves buying bonds with equally spaced maturity dates in order to reduce interest rate risk, by buying ETFs rather than individual bonds directly. 

Investors can also buy government and corporate bonds directly via an investment platform, a choice that many have made this year. That helps to lock in a guaranteed return, gives investors a level of control over the exact form of exposure (and maturity) they want, and can come with some tax advantages, because selling a government bond will not incur capital gains tax even if held outside a tax wrapper.

This tax consideration may well influence what you buy. We noted earlier this year that gilts with lower coupons (interest payments) were trading for lower prices, meaning investors amass most profits when the bond is redeemed. From a tax perspective, this looks more attractive than those bonds offering higher coupons, given coupons are subject to income tax.

As we have previously warned, however, investors plunging into bonds should be careful not to completely eclipse their allocation to equities, which are better equipped to hold up against inflation over time. Those picking up the juicy yields on bonds and good rates on cash accounts will also have to prepare for a time when putting cash to work at the same rates is no longer possible, and such cash needs to find a new home.