The Return of Bonds
Bonds are the unsung heroes (and sometimes villains) of financial markets.
For the average investor, stocks are easy to understand. They’re familiar with the companies that issue them, and the link between corporate performance and share prices is intuitive.
Bonds are a different proposition entirely. They are perceived as boring, complicated, even bewildering. “Duration”, “convexity”, “PV01”… Bonds come with an esoteric (and to us bond market folks, beautiful) language all of their own.
Unlike stocks, the performance of bonds is also somewhat counter-intuitive, since higher yields mean lower prices. They tend to outperform as underlying economic conditions deteriorate. And when rates are low for prolonged periods, bonds drop off the radar entirely – people are simply too busy chucking money at FAANG stocks, startups, and dubious crypto projects.
Bonds are back in town
For those of us who work in fixed-income, bonds never went anywhere. But for the general public, they are firmly back on the menu.
This was inevitable. Despite the best intentions of central bankers and the hubristic proclamations of politicians, we live in a cyclical world. 2022 was the worst year for core bonds in almost half a century, as the US Aggregate Bond Index declined by 13% on the back of the Fed’s most aggressive rate hiking campaign since 1980.
The years following bond market declines tend to see healthy returns, and that’s exactly what’s started to happen. Central banks across developed markets have aggressively raised rates to combat soaring inflation, presenting investors with a compelling case to load up on high-yielding safe-haven assets.
Shopping around
The main reason for the resurgence of interest in bonds is the relative value they offer versus other asset classes.
Indeed, the Equity Risk Premium (the extra return investors can expect for holding stocks over risk-free government bonds) looks perilously low at 1.72%, hovering around its lowest level since before the Great Financial Crisis. Pitched against 12-month T-Bills at 5.34%, bonds (especially short-duration ones) look pretty attractive.
That being said, if you’re a retail investor, it’s worth having a look at your baseline alternative – savings deposit rates. The headlines in the UK are all about profiteering banks not passing on higher rates to savers, but that is largely focused on the Big 4 high street banks. If you go onto price comparison sites, you can see some smaller banks offering savings yields north of 5%.
The return on bonds does need to be significantly higher than that to justify the effort. But, for those with savings / investments more than typical deposit insurance limits, bonds are starting to look really attractive.
The ETF angle
Of course, there’s always the option of buying an ETF. But these expose investors to mark-to-market risk. If central banks keep raising rates, then the NAV of the ETF could go down (even if it’s still paying out income).
Investing directly in bonds ensures that the price always “pulls toward par”. In the UK, you can take advantage of the tax advantageous nature of gilts (no capital gains tax), and buy the 28-year gilt (UKT 0.5% 2061) at a cash price of 28.40. The yield is “only 4.37%,” but with such a low coupon, almost all of the yield comes in the form of capital gains, which is tax free.
You do have to wait until 2061 to collect, though.
Long duration, short credit
Of course it's too simplistic to say that all bonds are back. The fixed-income asset class is exceptionally diverse, catering to the full gamut of risk/reward appetites.
Government bonds are in vogue, but we are yet to understand how aggressive rate rises from central banks will impact the private sector. We’re all hoping for a soft landing, but this is far from assured. “Long duration, short credit” has been a popular call amongst portfolio managers in recent months, for good reason.
After years of being overshadowed by high-flying stocks and innovative (and some just plain stupid) financial products, bonds have made a remarkable comeback. As a through-and-through “bond guy”, it’s nice to see fixed-income getting exciting again after over 10 years of hibernation.
Let’s hope the bond market stays in the headlines for the right reasons!