Should you be buying bonds?

Anyone with a passing interest in financial markets will know that bonds – including UK government Gilts – have been under huge pressure throughout 2022 – by Matthew Roche, Associate Investment Director at Killik & Co.

 
Already high Gilt yields rose sharply after the ill-fated mini-budget in September, before stabilising somewhat upon the appointment of Rishi Sunak as Prime Minister This stability has been consolidated further following the new Chancellor’s Autumn Statement.

Investors with bonds in their portfolios had seen their capital value fall sharply – but this volatility also set up a potentially attractive landscape for those new to fixed-income markets, or investors seeking to up their exposure to bonds. Fast forward to today, and we’re seeing bonds begin to recover, albeit tentatively, as investors show optimism that we’re through the worst of the volatility.
 

How do bonds work?

 
Governments and companies issue bonds to raise money. When you buy a bond, you are essentially providing a type of loan. Like most loans, bonds are paid back over a set amount of time and with interest, though in this case the interest on a bond is fixed at the point of purchase over the entire period. The interest payments – known as coupons – are paid to the bond holder every year until the agreed period end and the original loan is repaid.

Bonds are also traded on the secondary market and can change hands for more or less than their original value. Prices here are heavily influenced by interest rates – as they go up, the returns provided by bonds become less attractive in comparison.

When this happens, the market value of a bond goes down to compensate for the smaller relative return. In other words, lower prices = higher yields, higher prices = lower yields. In turn, this pushes up (or lowers) borrowing costs for governments and businesses issuing new bonds.
 

What is a Gilt?

 
British government bonds are known as Gilts (on account of the original certificates issued by the government having gilded edges) and have typically been seen as a low-risk investment. Pension funds typically invest more than half of their assets in Gilts to ensure they are able to pay pensions decades into the future.

Gilts have been in particular focus in recent months because of the fallout from the fiscal policies announced by the Truss administration. With no clear way to pay for tax cuts, confidence in the UK government’s ability to repay its debts was damaged and investors rapidly disposed of their Gilts. Pension funds were at particular risk, the UK market was in turmoil and the pound dropped to an all-time low. Fortunately, UK Gilts appear to have settled back down for now.
 

Why have bond markets been so volatile?

 
The background to the current bond market lies in the inverse relationship between fixed-income securities and interest rates – higher rates result in lower bond prices. As rates go up, bond returns become less competitive and, therefore, less attractive. This effect has taken hold as central banks have hiked base rates to control inflation.

Sentiment is also a major driver of market movement. When investors become more risk averse, they tend to demand higher returns from all assets, including bonds and Gilts. Given the economic outlook, this cautious sentiment has been having an effect for months.

In September, the mini-budget triggered a huge sell-off of bonds. Yields on 30-year Gilts rose to a peak of 4.99 per cent from just 1.1 per cent at the beginning of the year. The Bank of England had to step in and buy these long-dated government bonds to prop up prices. These prices have stabilised somewhat since the majority of the government’s fiscal plan was scrapped and measures to reduce the UK’s debt were set out in the Autumn Statement. Following the Chancellor’s statement, with yields on 30-year Gilts now back down to a level of around 3.4 per cent.
 

Is this the right time to buy bonds?

 
Although many believe the worst of the market volatility is behind us, it is undoubtedly a time of increased uncertainty for the UK economy, and consequently, all investors – the general level of nervousness and unease is not going away, especially following the Chancellor’s announcement that the UK has entered a recession. Although yields have begun to go subside, the overall increase in bond yields has also meant higher borrowing costs across the board, which is bad news for companies and governments.

Currently, the bond yields on offer are proving tempting for many investors, particularly in comparison to holding cash, the value of which is still being eroded by inflation despite higher returns. For many, high quality bonds could represent a good value source of income, especially if stock market investors are hit by recession as we’d expect – in times of financial crisis, many revert to buying bonds as a so-called ‘safe bet’.

Furthermore, bonds can be held in tax wrappers, such as ISAs and SIPPs. Even when held outside tax wrappers, most bonds are not liable for Capital Gains Tax. This is significant when bonds are purchased below the redemption price paid to the holder on the maturity of the bond.

There are, of course, risks. Despite the relative return to calm, in the medium-term, there is likely to be continuing volatility linked to market expectations of inflation and interest rate movement, and a related risk premium remains. Corporate bonds may also be seen as a riskier option now that the government has confirmed recession, with a much greater risk of losses.

We would always recommend seeking expert advice. There is a dizzying array of corporate and government bonds with a range of names, maturities and coupon prices. It’s important not to confuse the latter with the bond’s yield. And, as with stocks and shares, it’s vital to build a diverse portfolio of fixed-income securities to limit risk.

It is also worth considering some of the wider benefits of higher bond yields. They will, in turn, boost yields elsewhere, such as annuities. That is potentially good news for savers and retirees, for example.