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Bonds have had a tough time over the last 12 months, but with that comes opportunity. We look at whether now’s the time to revisit bonds.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
All information is correct as at 30 September 2022 unless otherwise stated.
Picking ‘the bottom’ of any market is nigh on impossible, even for the most experienced investors. Therefore, this article isn’t meant as some sort of indication that bonds won’t fall further in value from here. But questioning whether your portfolio might be in need of a bit more bond exposure (or indeed for many people, some bond exposure) makes more sense now than it did 12 months ago.
Since 2021, central banks the world over, from Equatorial Guinea and Rwanda, to the US and UK, have raised interest rates. The impact on bonds has been a fall in prices and increase in yields, or interest payments. If you’ve held bonds in your portfolio during this period, you’ll likely have seen these fall in value. If there are further interest rate rises, there could well be further falls in value too.
However, the point is this – at the start of 2022, 10-year government bonds from the US, UK and Germany were expensive, meaning the yield you earned by owning them was 1.5%, 1.0% and -0.1% respectively. The yields on the same bonds as at 30 September 2022 were 3.8%, 4.1% and 2.1%.
This is a big difference.
This fall in value and increase in yield has occurred across all types of bonds, not just government ones.
The S&P Global Developed Corporate Bond index had a yield to maturity of 1.8% as at 31 December 2021. This was 5.2% on 30 September 2022. Similarly, the S&P USD Global High Yield Corporate Bond index had a yield to maturity of 6.1% as at 31 December 2021. This was 10.6% on 30 September 2022.
These yields are the averages of the bonds contained within these indices, there are lots of bonds within them that have higher and lower yields. Remember though, yields are variable and not guaranteed. For bond funds, they’re not a reliable indicator of future income and are just a snapshot at a point in time.
These are attractive levels of income when compared to dividend yields available from company shares. The following table shows a number of dividend yields from different equity indices as at 30 September 2022:
|MSCI AC World||2.46%|
|MSCI Emerging Markets||3.63%|
|MSCI World REITs||3.83%|
Source: MSCI, 30/09/22.
So, on 30 September 2022, you’d have been paid a higher yield for buying US 10-year government bonds than if you invested in the MSCI AC World index. But remember, the potential for rises in the value of the bond are more limited than for the equity index.
To most, there’s no such thing as a free lunch. There are very good reasons why these bonds have fallen in value and are now offering notably higher yields.
Inflation, which is excessively high currently, means the fixed rates of return you typically receive from a bond aren’t worth as much now as they were 12 months ago in the real world. If you held a bond 12 months ago and it was paying you a yield of £5 a year, you could have bought five cheeseburgers from McDonalds. If you still owned that same bond now, that £5 can only buy four cheeseburgers. Other fast-food restaurants are available.
So, the value of your yield in the real world has decreased, well in terms of cheeseburgers that is.
There’s also the possibility of further interest rate rises by central banks. This could increase yields even more from here. So, you could be better off not buying bonds now but waiting for yields to increase further and buying the same bonds in the future, but at a cheaper price.
We’re not interested in playing this game. That’s because many people lose at it. Nobody knows whether bond yields are going to rise or fall over the short term.
Over the long term, this is a different question. Will bond yields be lower than they currently are at some point over the next five years? It’s possible. Over the next ten years? It’s more possible.
The graph below shows the 10-year US government bond yields since 2003 to September 2022.
Scroll across to see the full chart.
Source: Refinitiv Eikon, 30/09/22.
As you can see, the last time the US 10-year government bond yield was at the 3.5% level was in 2011.
Therefore, even if bond values fall further from here, at some point these bonds could be at least at their current price, or maybe higher. And you’ll have received an income of around 3.8% per annum in the interim.
Another concern is a recession, both in the UK and more widely around the world. In August, the Bank of England stated it expects the UK economy to go into recession before the end of 2022 and stay in recession throughout 2023.
That increases the chances that companies will make less revenue and profit and in turn won’t be able to pay back their debts.
A good way to invest in bonds is through a fund – that way you can invest in lots of different bonds at once, spreading the risk. If you’re investing in funds though, it’s important to consider whether to invest in an actively or passively managed fund.
An actively managed fund will have a manager that chooses which bonds to invest in. A good manager should be able to help avoid companies that might default on their bonds. They should also be able to select better value government bonds, whether that relates to the length of the government bond, or which governments to buy bonds from. However, even good managers can be caught out.
A passively managed fund will simply invest in all of the bonds included within an index. Therefore, you’ll automatically be invested in some companies that will default on their bonds, as well as potentially less attractive government bonds.
So, there are risks.
But if you’re able to take a longer-term view and invest with a fund manager who’s good at picking companies able to pay their debts, bonds could offer a reasonable return.
Yes, they could fall in value over the near term. But if the global economy improves and inflation reduces, it feels like there’s a good chance bonds will end up higher in value than they are today. And you’ll receive the yield along the way. Of course, there’s no guarantee though.
Bonds might not be for everyone, but they’re a lot more attractive now than they were 12 months ago.
There are several bond funds on our Wealth Shortlist – a selection of funds our research team has identified as having the potential to outperform their peers over the long term.
Explore our Investment Times autumn 2022 edition for more articles like this.
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