A combination of high inflation and interest rate hikes has led to growing investor interest in bonds, but investors will need to think carefully if bonds are right for them over the longer term, says AJ Bell.
A rise in yields means today’s investor can get a 4.5% annual yield on a UK government bond maturing in 10 years’ time, significantly above the 0.2% during the pandemic in 2020. It means that if an investor had invested £10,000 in a bond yielding 0.2% per annum and held it to maturity, they would receive £10,202 after 10 years. In comparison, a bond yielding 4.5% would result in a return of £15,530.
Laith Khalaf, head of investment analysis at AJ Bell, said: “The bond market has definitely woken up and is offering more compelling value than it has for a long time. The yields on bonds will look pretty tempting after the income drought of the 2010s.”
According to Khalaf, 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.
Khalaf said: “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. If correct, that suggests there’s not much more yield to be squeezed out of the market.”
However, Khalaf said that despite attractive yields, the outlook for bonds “is not without its risks.” Over supply may pose an issue, while a credit rating downgrade for the US government could unsettle markets, in addition to upcoming elections in both the US and the UK.
Corporate bonds are priced off government bonds and so some of the same concerns prevail, said Khalaf. In addition, investors need to be more aware of default risk, or perceived default risk, feeding into prices.
Higher interest rates also present a problem for companies and those refinancing their debts at today’s market rates may find themselves faced with a sharp rise in interest payments, with one third of the profit warnings from UK companies issued over the summer citing tighter credit conditions – the highest level since 2008.
While the lower volatility of bonds tends to make them favoured for lower risk investors, AJ Bell warns they can also experience significant downdrafts too.
Khalaf said: “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.”
There are essentially two key reasons for investing in bonds: income and diversification. Bonds typically provide investors with a certain 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.
Khalaf said investors should consider a bond allocation in the context of other assets such as equities and cash, with shares likely to deliver better returns than bonds over the long term.
He added: “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.”
