Don’t lose sleep over the ‘Bond Bubble’

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10 Jan Don’t lose sleep over the ‘Bond Bubble’

An increasing number of people in the investment world are convinced that bonds are overpriced and are bound to fall at some point in the future. The logic often goes like this:

1. Since interest rates in the UK and in other countries are at record lows, they can only go one way.
2. If interest rates go up, bond prices will take a hit and portfolios will be decimated.

The problem with this view is that it ignores a few important points:

  • The market is expecting interest rates to rise, at least in the short term. Current bond prices already reflect this expectation of a possible interest rate rise and the likely consequential fall in bond prices.
  • If interest rates rise as the market expects, bond prices might fall in the short term, however, the total return on bonds is made up of the coupon (or the interest rate) and the price. Take for instance, the case of a 10-year bond with a face value of £1,000 paying 2% per annum. I f interest rates rise, that bond still pays you the interest of £20 every year, even if the face value drops to say £950. And, you get your principal back upon maturity.
  • A recent research paper by Vanguard examined the likely total return on bonds based on the current market expectation of a possible interest rate rise. It is crucial to bear in mind that this research isn’t forecasting what bond prices will do. What it does, is to consider likely implications if the current market expectation of interest rate rises materialise. The research shows that, while bond prices might fall in the event of a rise in interest rates, the total return of a 10-year government bond is still likely to be positive in the longer term. This is because the coupon (the interest rate) on bonds more than makes up for the fall in price.

Bond graph

  • Crucially, it is important to realise that not all bonds are equal. High quality (investment grade) bonds typically tend to provide a better buffer to equities. Low quality (also known as high-yield, or sometimes junk) bonds tend to provide less of a buffer to equities. Furthermore, it’s important to know why you own bonds in the first place and understand their risk/reward profile.
  • It is unlikely that all rates across the world will increase at the same time or in the same magnitude. Even if the expected returns on bonds in one country is negative, expected returns in another country might be positive. The flexibility to pursue higher expected returns by investing in bonds around the world can be an important defence against low and even negative yields.

At Tandem, our approach is to hold high-quality bonds with a high level of diversification, globally across different maturities. Bond prices may fall in the short term – a relatively common occurrence. But global diversification provides an effective tool for reducing risk and improves expected returns in the long term. The high investment grade reduces the risk and volatility. Therefore, we don’t lose any sleep over the likely impact of interest rate rises on bonds and we hope you don’t either.